Your mortgage may have locked you into a serious financial commitment that could last up to 30 years. But did you know you can pay off your mortgage a lot faster, and break up with your mortgage lender? That’s right! By taking advantage of the mortgage prepayment options available, you can subtract years off the life of your loan and save yourself thousands of dollars.
But while becoming debt free years sooner and owning your home outright may seem like a no-brainer, is it the right option for you? There are a lot of things to consider before throwing any extra cash you have into your mortgage. Taking some time to review the pros and cons of prepaying your mortgage will help you make the best decision for your situation
The Benefits Of Prepaying Your Mortgage
Almost half of Canadian homeowners are spending about half of their monthly income on their mortgage payment alone. And while that may seem like a startling statistic, the truth is, most homeowners can still afford to pay more. So why don’t they?
Housing prices have seen impressive growth in the last few decades, which means it now takes anywhere from 15 to 30 years to pay off your mortgage. While interest rates may be low right now, don’t let that distract you from the true cost of borrowing.
Let's pretend you bought a house for $400,000. The average rate on a 5 year term fixed-rate mortgage was about 5% in 2020, so let's use that as an example. Assuming your rate never changed for the entire amortization period, your total cost of credit (the total amount of interest you pay over the life of the loan) would end up costing you about $302,000 in pure interest on a 25 year mortgage. Yikes!
Lump Sum Payments
One of the easiest ways to quickly pay down your mortgage is with lump-sum payments. Maybe you’re a great saver and have a nice balance tucked away, or maybe you received a little windfall from a salary raise, inheritance or you won the lottery. Whatever the case, different banks will have different conditions regarding lump-sum payments. Some institutions might let you make a lump-sum payment equal to 20% of the original principal. While others may only allow 10%.
Some will let you make several lump-sum payments over the term, while others might only allow you to make one lump-sum payment each year on your mortgage anniversary date. There are also likely to be restrictions on how much you can pay. It’s important to know exactly how your lender has structured prepayment privileges so that you don’t get nailed with penalties. Yes, you will get punished for paying too much too early so make sure you speak to your lender before making any extra payments.
Typically, banks will charge you about 3 months worth of interest on the remaining balance if you pay your mortgage off in full before the term is up for renewal. You will also get nailed just for paying more than the prepayment privilege, even if you didn’t pay the mortgage in full.
Let's pretend CIBC financed your mortgage. After your down payment and all closing costs, you ended up with a principal mortgage balance of $400,000 on a fixed-rate 5 year term at 5% interest, amortized over 25 years. That means you are locked in at a fixed rate and payment and cannot make any changes for the next 5 years until your mortgage comes up for renewal, at which point you can renegotiate the terms. But CIBC says that you can make extra lump-sum payments equal to 10% of the original balance in a calendar year. That puts your lump sum prepayment privilege at $40,000.
But then your filthy rich uncle in Florida dies and leaves you a small inheritance of $75,000. So you decide to put the whole thing down on your mortgage. But that’s $35,000 more than you're allowed to pay. So CIBC charges you 3 months’ worth of interest on just the excess portion of your lump sum. That prepayment penalty will cost you about $438.
0.05 annual rate / 12 months = 0.0042 monthly interest rate
0.0042 x 35,000 = $146 interest per month
$146 x 3 months = $438 three month interest penalty
Even in the face of prepayment penalties, it’s crucial you weigh the pros and cons to determine if the long-term benefit of prepaying more than what your contract allows is worth it. In this example, the penalty maybe $438 on an extra $35,000 above the prepayment privilege. But if you didn’t put that extra $35,000 down on your mortgage and just stuck to your prepayment limits, that $35,000 left on your mortgage would end up costing you almost $26,400 in pure interest over the life of the loan. As you can see, a $438 penalty is a small price to pay in order to save over $26k in interest.
Increased Monthly Payments
Some lenders will let you opt-in for a higher monthly mortgage payment in order to pay the mortgage down faster. That means your mortgage payment on a $400,000 home over a 25 year amortization period at a 5% interest rate would be about $2340.00 a month.
Most banks allow you to pay up to an extra 20% of the monthly payment. An increased payment amount means you can opt-in to pay more than the minimum mortgage payment. Let’s use our previous example of a $400,000 5 year fixed-term mortgage at a 5% interest rate amortized over 25 years. If you took full advantage of that offer, you could opt for a mortgage payment of $2808. But wait, where did we get that number? 20% of $2340 is $468. So you would add that $468 to your existing mortgage payment, bringing it up to $2808. By paying that extra 20% every month (an extra $468 on top of your minimum mortgage payment) you reduce the life of your loan by almost 7 years and save over $93,000 in pure interest. That extra $468 a month adds up to considerable savings and a huge leap towards living mortgage free sooner.
Accelerated payments are simply just changing how often you make your mortgage payment. Most mortgage payments are set up monthly, but with accelerated payments you may choose to pay weekly or biweekly. For example, using our hypothetical $2340.00 mortgage payment, instead of paying that once a month, your bank may let you pay $1170.00 every two weeks.
In one calendar year, there are two months that Canadians will receive a third bi-weekly paycheque in the same month. The same goes for your mortgage too. If you opt-in for a bi-weekly mortgage payment, you’ll automatically be making a full extra payment onto your mortgage over the course of the year. Of course, depending on the size of your mortgage and the amortization period, you’re not likely to make much headway at all with this method. The cost of borrowing is so high that one extra payment a year is not going to result in any mind-blowing savings.
The Downside Of Prepaying Your Mortgage
One of the major downsides of prepaying your mortgage is cash flow, specifically if you choose the increased monthly payment from our earlier example. Banks love restrictions so much they throw them around like confetti. If you opt-in for the higher monthly payment then you are likely locked into that payment and cannot change it until your mortgage comes up for renewal. That could be anywhere from 2 to 5 years (or longer). If your budget is tight and you get hit with a surprise expense, critical illness or job loss, you can’t just ask the bank to lower your payment. You are fully committed to that higher payment.
And it’s not just budgeting and cash flow you should be concerned about. There’s also the opportunity cost to consider. What do we mean by that? Well, every decision you make has a tradeoff. If you choose to put extra money onto your mortgage, that’s money that could have been put elsewhere to benefit you in some other way. Is it in your best interest to be paying down your mortgage if you aren’t maxing out your RRSP or TFSA? Does your employer offer contribution matching? Depending on your situation you could be missing out on serious tax benefits in addition to leaving free money on the table by not taking full advantage of your employer’s RRSP matching program.
You also need to consider the opportunity cost of not investing in the stock market through an online broker or a robo-advisor, which has historically produced more robust returns than the housing market. Over the last 30 years, the stock market has produced market returns in the range of 7-10% with the housing market consistently trailing behind at just over 2%. Let's assume a 7% return on investing in the stock market. Instead of putting that extra $468 a month onto your mortgage, you could make monthly investment contributions of the same amount and let market returns and compound interest work their magic.
Over 25 years you could be looking at a nest egg of about $380,071.06 (before taxes, because the government is awesome like that). That’s 4 times more money than you would have saved adding that same $468 to your monthly mortgage payment. Of course, there are risks involved with investing in the stock market so you’ll need to assess your own risk tolerance and what makes the most sense for your situation.
And how is the rest of your debt looking? Are you carrying a lot of high interest consumer debt like credit cards? If your debt load outside your mortgage is considerable it may be advantageous to aggressively pay down your high interest debt first. And not just that, but any other debt like student loans, cars, lines of credit, etc. There are many benefits to consider with this approach, such as getting out of debt faster, increasing your credit score and setting yourself up for a better mortgage rate down the road. A higher credit score and a lower debt-to-income ratio means you’ll be able to negotiate a much lower interest rate on your mortgage when the time comes to renew.
What Should You Do?
The answer to that question depends entirely on your personal financial situation. There are many variables to consider like the size of your mortgage, the rate, how much debt you have and your retirement goals. If investing instead of paying down your mortgage piqued your interest, you also need to consider what your risk tolerance is as well as your time horizon. Paying down debt is never a bad decision. But you can’t ignore the benefits of investing in your future either. There could be a better option that you may not have considered. Taking an in-depth look at your whole financial picture and weighing the pros and cons will help you make an informed decision so that you can craft the perfect financial strategy for you.