Why are prepayment rights so important?

Prepayment rights are often not the key consideration when obtaining a mortgage. Borrowers normally look to secure the lowest rate of interest possible at the amount of money they require. In doing so, borrowers forgo the benefit of having an “open” mortgage to obtain the lower interest rate offered for a “closed” mortgage. Open mortgages are open to prepayment of any amount at any time, without a penalty. Borrowers choosing open mortgages normally pay a premium to obtain this benefit, so most residential mortgages are closed to prepayments. Closed mortgages have restricted prepayment rights, resulting in a borrower having to pay a penalty for paying the mortgage before the end of the mortgage term.

Prepayment rights in closed mortgages vary, but normally permit 10-20% of the original principal amount be prepaid without penalty, subject of course to certain restrictions. The typical prepayment rights allow a borrower to prepay a percentage amount each year but also permit the borrower to increase their monthly payment by a set percentage each year. Sometimes these options are mutually exclusive, and sometimes the lender will permit the borrower to utilize both in the same year. Some borrowers have additional options that permit double payments. When a borrower uses the prepayment option, the funds paid back to the lender are applied to principal, thereby reducing the amount borrowed and shortening the time within which a borrower will repay the entire mortgage amount. When this is done, the lender will make less money given that the borrower will be paying less interest over the mortgage term, which is why lenders restrict the borrower’s right to prepay.

When a borrower wants to sell the property encumbered by a mortgage, this will terminate the mortgage unless the borrower is going to move this mortgage to a new property – an option called “porting”. Lenders normally permit the mortgage to be prepaid prior to the term’s expiry, subject to the borrower paying a penalty. The standard prepayment penalty is set at an amount equal to three months interest. Most mortgages have a requirement to pay the greater of three months interest, or the amount called the “interest rate differential amount” which we explain in a separate section (accessed here). These prepayment amounts can be substantial, and well above what a borrower thought they must pay. As such, a borrower should always confirm the prepayment amount with their lender before agreeing to sell their property or payout their mortgage.

In summary, your ability to prepay your mortgage in full or in part will be set out in your prepayment terms. If you expect to have the ability to prepay a substantial amount of your mortgage, you should consider negotiating for a higher annual prepayment amount than the standard 10% as this could save you a lot in prepayment interest. You should also pay attention to the prepayment percentage when you may be in a position to be transferred or have to move, as many benefit plans do not include compensation for prepayment penalties.

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