What Is a Prepayment Penalty and What Are Your Workarounds?
Prepayment Penalty 101
When you sign a mortgage contract, your lender will specify the amount of mortgage you must pay back each month. Given the rising rates of interest charged on mortgage loans, it may seem tempting to try and pay yours off as soon as possible. Unfortunately, if you pay off more of your mortgage than you are allowed to, or attempt to pay back your loan too early, you may be charged a prepayment penalty by your lender.
A prepayment penalty is a hedge against the risk you pose to your lender. There are many economic incentives for a borrower to refinance their subprime mortgage, but this is not a great arrangement for lenders. Most lenders make their money back through interest payments and rely on those payments to profit from loan origination. If a borrower pays off their mortgage too early, the lender will not make as much profit off of the interest payments. As such, prepayment penalties allow lenders to still earn the profit they require and make some, if not all of, their money back.
The good news is that your prepayment penalty should not come as a surprise. Lenders are legally required to disclose prepayment penalties in the clauses of your mortgage contract, and these terms can sometimes be negotiated at closing. Applicants with better credit scores and debt histories, as well as higher incomes, may be granted better terms as they pose less of a risk to the lender. It is critical that you pay attention and carefully read through the prepayment clause of your mortgage commitment. A good mortgage broker will take the time to read it with you and explain it to you in detail.
For more information on how to present yourself as an attractive applicant, check out our comprehensive guide to getting a mortgage in 2022 .
What Are the Benefits of Paying Off a Loan Early?
While prepayment penalties may be a strong deterrent, it is important to recognize that paying off your loans early may come with a few advantages.
First and foremost, the sooner you pay off your mortgage loan, the less money you will spend on interest payments, provided that the prepayment penalty does not outweigh your future interest costs. Not only might you incur less interest by making fewer, larger payments, you might also reduce your overall cost of borrowing. Interest charges, like with most loans, buy you nothing but time.
Furthermore, an early pay-off will lower your debt-to-income (DTI) ratio. Your DTI ratio compares your total debt against your total income and is used by lenders as a measure of your potential borrowing risk and your fiscal responsibility. A lower DTI ratio appears more favourably to lenders, and may help you qualify for better terms and rates down the road. By paying off your mortgage early, and lowering your debt-to-income ratio, you may be able to qualify for better loans with better terms and save more money in the long-run.
Finally, one of the biggest advantages of an early pay-off is achieving greater peace of mind. Once you finish paying off your mortgage, you free up additional cash to be used for other expenses. You may be able to afford an investment property, vacation home, a nicer car, a better wardrobe, or more frequent vacations. Whatever you choose to do with your money, you now have the freedom to do so. You also relieve yourself of the hassle associated with monthly payments. Having to make large, regular payments can be stressful, and you may be afraid of accidentally missing a payment. The sooner your mortgage is paid for, the sooner you can rest, relax, and enjoy yourself.
How to Safely Pay Off Your Mortgage Early
While many attempts to pay off your mortgage early will result in prepayment penalties, there are some loopholes you can consider:
Take Advantage of Your Prepayment Privileges
A prepayment privilege is an amount, set out by your lender, that you can pay on top of your typical monthly payment without being charged a prepayment penalty. Each mortgage contract is different, and each lender may allow different prepayment privileges. If you are looking to pay off your loan as soon as possible, you may want to take full advantage of your prepayment privileges to increase your monthly payments. Through doing so, you will also incur prepayment penalties on a smaller mortgage balance.
Port Your Mortgage
If you are looking to break your mortgage contract early in order to move to another home, you may be able to avoid prepayment penalties by porting your mortgage. When you port your mortgage, you simply take the mortgage rate and contract you have with your current lender, and transfer it to your new property. You will, of course, still need to pay the down payment on your new home, but porting can save you and your lender a lot of hassle.
Through porting, you will not damage your credit score, and will avoid the extra costs that you would incur by breaking or defaulting on your mortgage. It is important to recognize that porting your mortgage does cost money. However, this figure is par less than the value of a typical prepayment penalty.
Porting your mortgage is especially beneficial if interest rates have increased since you first signed your mortgage contract. Through porting, you keep the original terms of your contract even after transferring it to your new property. As such, you save money on the interest payments you would have incurred otherwise.
To learn more, check out our guide on porting your mortgage.
Consider Your Options
When choosing a lender and a mortgage, it is important to shop around and consider all your options. Your ability to pay off your mortgage quickly will depend on the requirements and terms set out by your lender. Here at Clover Mortgage, we have worked with a vast network of over fifty lenders. Our expert team will evaluate your unique financial situation and pair you with the perfect mortgage for you.
Contact Clover Mortgage today to book your free consultation! Call us at 416-674-6222 or email us at info@clovermortgage.ca anytime!
Resources
