Though not offered by all banks/lenders, it can really come in handy to utilize the option to prepay a mortgage (if/when the option in available). However, to avoid confusion, this blog will focus on two very different types or mortgage prepayment.
What does it mean to prepay a mortgage?
- To prepay a mortgage can mean to take advantage of a privilege that is offered through most standard first mortgages (typically institutional mortgages). This option allows you to make payments (in addition to your regular scheduled payments) toward your mortgage at any given time throughout your term. Any payments made to prepay a mortgage will go straight to the principal balance owing with no interest deducted. Usually the maximum is between 15% – 20% of your outstanding balance each fiscal year. This is a great way of paying down principal as a strategy of paying off your mortgage sooner than scheduled.
- To prepay a mortgage can also mean to literally pay, in advance, your monthly installments (either in full or partially) to eliminate or reduce your monthly payment obligation to that mortgagee. This is usually only available for private mortgages, whether a first or second mortgage. When you prepay a mortgage in this manner, what you are doing is essentially deducting the prepayment at the time of advance which is then used to service the mortgage. In simpler terms, you are using the funds from the mortgage to pay for the mortgage itself – hence the mortgage prepayment.
Here is an example for each to help illustrate how to prepay a mortgage:
- Prepay a mortgage as part of a pre-payment privilege. Sally has a first mortgage with First National. First National, as part of their standard terms, offers 15% prepayment privileges to all of their clients. Currently, Sally has a balance on her First National mortgage of $300,000. Her monthly payments, not including property taxes, are installments of $1546.97. This installment is a combination of principal + interest and therefore, part of her monthly payment goes toward interest while the remaining goes toward reducing her balance owing. Sally has come across $30,000 from investments and wants to prepay her mortgage. $30,000 does not exceed her 15% pre-payment privilege and therefore she can utilize the entire amount. Since this pre-payment privilege does get charged interest, once she provides her pre-payment, her new balance will now be $270,000. By doing Sally will likely pay off her mortgage approximately 2 years earlier than if this pre-payment was never made.
- Prepay a mortgage as a way of reducing/eliminating the monthly payment: John needs a second mortgage of $40,000 to help consolidate debt. He is having serious cash flow issues, so he needs to keep his payments as low as possible to ensure that his finances improve before his plan to refinance/consolidate his mortgages in 12 months. The second mortgage would cost $400/month without prepaying it, and though paying off all of his other debt will help his finances, maintaining an additional mortgage for $400/month will still be hard for John at this moment in time. Thankfully many lenders allow clients to prepay a mortgage. What happens in a scenario such as this is the lender will deduct $4800 ($400/month x 12 months) from the proceeds of the mortgage while advancing only the difference (minus applicable closing costs of course). By holding back $4800, this will contribute toward a full pre-payment of the mortgage for the 12 months term thus resulting is John not having to make any payments at all throughout the year. This is the scenario that worked best for John, however if someone wanted to partially prepay a mortgage, instead if prepaying in full, this can also be arranged. Using the same example, if $2400 is used to partially prepay the mortgage, the monthly payment is now reduced to $200/month instead of $400/month thus making the payment more manageable.