What Is A Prepayment Privilege?
Want to know more about prepayment privilege and how it works? Read this blog to find out,
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Have you worked hard and saved some surplus cash? Are you willing to use it to shave off some portion of your existing mortgage loan?
If yes, then going through this article becomes necessary for you as we will tell you everything about prepayment privilege and the associated prepayment penalty.
What Do You Mean by Mortgage Prepayment?
A mortgage prepayment refers to the additional amount you will pay over and above your monthly mortgage payments. It reduces your outstanding loan amount and helps you to enjoy the benefits of either of:
- Reduced tenure of the mortgage loan
Or
- Reduced monthly mortgage payments
Besides the above benefits, making consistent mortgage prepayments can also help you save thousands of dollars in interest costs. You will realize your long-term financial goals a bit earlier.
What Are the Different Ways in Which You Can Make Mortgage Prepayments?
We can make a mortgage prepayment in several ways, which are:
- Decide a specific fixed amount and keep paying it every year towards the outstanding.
- Enhance your monthly mortgage payments by a few dollars and stick to it throughout the year
- If you are expecting a windfall gain or any amount out of the inheritance, then you can use it for the prepayment Purpose
- Recasting your mortgage terms
- A combination of the above methods
What Happens When You Make Mortgage Prepayments?
The significant advantage you get by making a mortgage prepayment is that you will pay lesser interest. Every considerable mortgage prepayment reduces your outstanding principal amount of the mortgage loan. It leads you to substantial savings in the interest expense.
We can understand this via the below example:
Alex is a full-time employee with a private company in Canada. He has taken a mortgage loan of $250,000 for 5 years at 4.5% per annum in March 2022. His monthly mortgage payments are $4,661, and over five years, he will pay a total interest, amounting to $29,645.
In January 2024, Alex contemplates receiving inheritance money of $60,000, which he wants to use as a prepayment towards his mortgage loan.
As per his calculation, the opening balance in January 2024 will be $164,781. After prepaying $60,000, he will have an outstanding principal amount of $104,781.
Now, all the future interest calculations regarding his mortgage loan will be done on this reduced outstanding balance of $104,781, instead of $164,781. It will help him save a substantial amount of interest cost.
What Is a Mortgage Prepayment Penalty?
A mortgage prepayment penalty is a fine or financial sanction levied by the lender upon you. You have paid an additional amount towards your mortgage loan above your monthly mortgage payments.
This penalty acts as a discouragement for the borrowers from making an advance payment towards their home loans as it reduces the ability of the lenders to collect interest.
Why Is a Mortgage Prepayment Penalty Levied?
The primary source of income for most lenders and financial institutions is the interest they earn. They charge on the amount disbursed as a loan.
When you prepay a part of your loan early, you are:
- Reducing your interest burden
And
- Reducing the net collection of interest that your lender was contemplating charging from you
Thus, a lender prevents itself from losing the interest income charges a penalty to discourage you from prepaying your loan amount.
What Is Prepayment Privilege in Mortgage?
A prepayment privilege is an amount a borrower can prepay before maturity, attracting no prepayment penalty.
If you are making extra payments towards your mortgage loans that are within the permissible limits as allowed by your lender, then you will not be required to pay any penalty or fine.
This permissible limit varies from lender to lender. However, commonly, you can prepay about 15% to 20% of the original mortgage loan amount, attracting no prepayment penalty.
Let us understand this with the help of an example:
Mr. A is a mortgage loanee and has taken a loan of $500,000 from a leading financial institution at a competitive interest rate of 3.75% per annum for 5 years. His mortgage contract comprises a prepayment privilege clause, which states that he can make a prepayment of 15% every year with no prepayment penalty.
It means that Mr. A can make a maximum prepayment of $75,000 ($500,000 x 15%) every year in a lump sum or parts, and he will not be charged any prepayment penalty.
Can the Limit of Prepayment Privilege Be Carried Forward to The Subsequent Years?
The short answer is NO. You cannot carry forward your prepayment privilege limit to any subsequent year.
If you have any balance left in your limit of prepayment privilege, then you cannot carry forward it to the next year(s) and add the carried forward amount to the limit of the next year(s). Instead, this unused amount will lapse in the current year itself.
When Should You Prefer Mortgage Lenders Offering Prepayment Privilege?
If you expect to repay your mortgage loan within less than the stipulated tenure, you must go for lenders offering prepayment privileges. It certainly helps you to save several thousands of dollars in interest costs.
On the other side, if you have no intention of paying off your mortgage loan early and want to pay monthly mortgage payments throughout the tenure, there is no point in searching for lenders offering high prepayment privileges. Instead, go for a lender offering an attractive and competitive mortgage rate, even though it offers a limited prepayment privilege.
