Rounding it up
Accelerated mortgage payments are a great way to free up some capital that you’re currently committing to monthly payments.
However, accelerated mortgage payments are not headache-free. They may come with prepayment penalties, depending on the type of mortgage contract you have.
These penalties can stack up into the five digits, so ensure you do the calculations and understand all terms before making any decisions.
Universal wants: Extra guac, a good hairline, and the ability to reduce our debt load. After all, decreasing debt allows you to put that cash elsewhere; maybe into savings or a big purchase like that sweet Caribbean vacation. The sandy beach, drinks with umbrellas… Yeah, that sounds perfect.
If your debt load includes a mortgage, you could look into accelerated mortgage payments. Your mortgage is probably one of your largest monthly payments, so paying it off early can help free up cash for other purposes. There are, however, a few things to consider when making accelerated mortgage payments. We’ll take a look at a few of the ways these payments can help, and maybe even hurt, your finances.
What are accelerated mortgage payments?
You pay extra on top of what you already owe. Let’s say you owe $1,000, $750 of which is principal (a portion of the amount you borrowed), and $250 is interest (the cost of borrowing money for the mortgage). You can pay an extra $500 a month on top of the $1,000 you’re already paying.
Alternatively, you could choose to do a lump sum payment. Again, let’s say you have a $1,000 monthly mortgage payment. You get a bonus at work and after treating yourself to a nice, celebratory dinner, you have $5,000 leftover. You can spend it as a single lump sum payment against your mortgage.
What are the benefits of accelerating your mortgage payments?
Many choose to accelerate their mortgage payment in order to reduce the total amount of money owed.
Extra payments almost always go to the principal, which would lower the total mortgage amount from which your mortgage’s interest rate is calculated. Thinking about it this way: If your interest rate is 1% of your principal, and your principal is 100,000, you’d owe $1,000 in interest. If your principle is $50,00, however, you’d owe $500 in interest.
Sounds great! Are there any fees?
It depends on whether you have an open or closed mortgage. Open mortgages allow you to make large lump sum payments and pay off your mortgage early without fees. However, they’re fairly rare in Canada and come along with higher interest rates than their closed counterparts.
On the other hand, if you choose to pay off a closed mortgage before its maturation date, you may be charged some prepayment penalties. Closed mortgage rates tend to be lower than open ones; you can think of it as your compensation for not being able to pay your loan off early.
What do these prepayment penalties cost?
Prepayment penalties are substantial but are not necessarily deal-breaking if you plan accordingly. Financial institutions will generally charge either three months of interest on the mortgage or the interest rate differential (IRD), whichever is higher.
With the former penalty, lenders will typically take one of two interest rates: Either the one from your mortgage contract when you signed or the current interest rate.
If the lender chooses to charge the IRD, they will multiply your mortgage balance by the difference of the interest rate you agreed to when you took out your loan and its current posted rate. Then, they’ll multiply that by the number of months remaining on your mortgage and divide it all by twelve.
Don’t worry, we didn’t follow that word math problem either. Perhaps an example will shed some light.
Let’s say you have a $100,000 mortgage that you took out at a 5% interest rate. You have 36 months remaining on your mortgage contract. The lender’s current posted interest rate is 2.5%., making the difference 2.5%.
Then, the prepayment penalty would equal = (the remaining balance x interest rate difference x remaining months) / 12.
Plug in the numerical values and the equation becomes ($100,000 x 2.5% x 36) / 12 = $7,500
So in this hypothetical situation, you’d be charged a $7,500 penalty to prepay your mortgage.
Do I have other options?
We get it — accelerated mortgage payments aren’t for everyone. You may not want to go through the hassle of sorting all of this out or dealing with the fees. Maybe your mortgage is simply too large. If you just need a bit more capital, you can consider mortgage refinancing. The process can also be a bit complicated but it can help lower your interest rate and free up capital from your home.
While accelerated mortgage payments can be a great way to reduce your debt load, it’s likely they’ll come with high fees since closed mortgages are very common in Canada. Ensure that you understand the impact accelerated mortgage payments will have on your finances before you decide to jump on it. If you need additional help, consider hiring a financial professional who can address your specific needs.
Dan is a runner and writer living in the Washington, D.C. area, where he currently works for a financial services trade association as the Communications Director.