A loan is a great blessing when we are not in a position to afford the payment for anything we desire to buy. No matter how carefully we plan our finances and loan repayments, monthly payments can take a toll on our wallets. Luckily, there is a change in our financial condition for any reason, such as an unexpected inheritance, a raise in pay, etc. In that case, the first thing that comes to our mind naturally is the thought of losing any existing loans to save on the interest rates and monthly payments.
However, the same optimism and happiness that comes to us in the form of the repayment of loans may not be reciprocated by our lenders for obvious reasons! The lenders would have anticipated a certain amount of income over the next few years, and by repaying your loan early, you are depriving them of the interest component. Usually, most lenders charge a prepayment penalty if you close your loan earlier than agreed upon. Albeit rare, some lenders do not include a prepayment penalty clause in the terms and conditions of the mortgage. If you are fortunate, your lender might allow early loan closure without charging you any additional amount.
How does a prepayment penalty clause come into action in Canada?
The average prepayment penalty on a mortgage is approximately 4-5% of the amount that is left unpaid on the mortgage. Let us walk you through the situations in which your lender can impose a prepayment penalty:
1. Most mortgage lenders set an annual payment limit with a ceiling on how much can be increased as a monthly payment or an annual lump sum payment that can be made towards the principal component of the loan. If this ceiling is exceeded, you may likely incur prepayment penalty charges.
2. If you refinance your mortgage or sell your house earlier than expected, then it is natural that with the sale proceeds, you would like to close the loan to have some breathing space concerning your finances. Depending on how close your tenure was to a natural completion of the loan, the prepayment penalty would differ.
3. When the terms and conditions of your mortgage are violated, the lender has the liberty to impose a prepayment penalty.
Please note that an open mortgage allows you to make a lump sum payment or a prepayment or foreclose your loan without inviting any prepayment penalties.
Is the prepayment penalty the same for all loans?
The charges towards the prepayment penalty depend on the type of mortgage and the conditions included while accepting the mortgage loan.
– In a variable-rate mortgage, the penalty is the interest you would normally pay for three months on the amount that is being paid early. Depending on your lender, This interest rate could be on the mortgage or prime rate.
– For a fixed-rate mortgage, the penalty could be the same as a variable-rate mortgage or an Interest Rate Differential (IRD) arrived at by your lender. To understand how an IRD works, let us take an example:
Let us assume that you took a mortgage of CAD 500,000 for five years at 5%. You have paid off $200,000 in two years and intend to pay the remaining 300,000 as you have received an inheritance.
Your lender would look at the rate they currently offer to anyone who purchases a three-year fixed mortgage from them- the current posted rate. Let’s assume that this is 7%. The IRD would be 7-5=2%.
Based on the IRD, your prepayment penalty is calculated as follows:
• 300000(balance amount)*1.4% (IRD)/12= $350
• This $350 is multiplied by the number of months that are remaining on your loan term, which is three years. e. 36 months. ( 36*350= $12600)
• So, you are likely to incur $ 12,600 as prepayment penalty charges, which is quite a significant amount.
Lenders charge an IRD in cases where the existing mortgage was signed less than 5 years ago and when the interest rate on your mortgage is either higher or lower than the prevailing interest rates in the market. If the interest rate on your mortgage is lower than the prevailing posted rate, it is called a discounted rate.
Since we are discussing prepayments and the penalties they attract, it can also help you know about Prepayment privileges. Certain lenders allow you to make an extra payment towards your mortgage payments apart from your regular payments without attracting a penalty. This proportion of how much is allowed as an extra monthly payment or a lumpsum amount varies amongst lenders. It is always advisable to go through the terms and conditions of the mortgage agreement in detail and note all the conditions concerning prepayment included in the agreement.
A cap or limit is applied on the amount that can be pre-paid on mortgages and is usually decided when signing up for the mortgage itself. Also, extra payments made on a loan in a particular year cannot be carried forward to subsequent years and adjusted against any unpaid monthly installments.
Is there a way to avoid/ reduce/minimize prepayment penalty charges?
There are certain prudent ways of minimizing the penalty charges. These methods include:
• Utilizing the prepayment privileges to the maximum extent possible every year. This will reduce the total term of your loan and decrease the final balance, which will be considered for penalty calculation.
• If possible, wait out the term of your loan so you can pre-pay a lumpsum amount without paying a penalty.
• If you are selling your old house and buying a new one, check with your lender if your existing mortgage can be ported with the same interest rate and terms and conditions.
• Never settle for the first refinancing or renewal of the mortgage offer that comes your way. Always look around and talk to mortgage brokers and lenders to choose a flexible plan.
• The easiest way to avoid a prepayment penalty is to choose an open mortgage plan that allows you to pay extra amounts as and when possible without any penalties. The only downside to this option is the possibility of a higher interest rate on an open mortgage than a closed or a variable one.
Becoming debt-free by closing a loan is often a milestone most of us want to achieve. Especially when we are trying to achieve the financial independence target, clearing our existing debts is the first task that needs to be completed. Yet, a word of advice that can be doled out here is that if the loan prepayment includes heavy penalties, it makes financial sense to continue making the mortgage payments and allow the loan to close at its decided term.
The extra amount you can spare after utilizing prepayment privileges can be re-invested into the market in a portfolio that can give you higher returns. Also, closing a loan early can adversely affect your credit score as well as there are no regular payments once the loan is closed. Before you decide to foreclose your mortgage, always seek advice from experts and your lender on the charges for closing the loan and make an informed decision based on your financial situation.
Q. How can I save money to pay my loan earlier than its tenure?
Saving money requires a lot of daily planning and execution, including savings automation and many other activities that can be taught as money-saving habits.
Q. Is my credit score impacted by a foreclosure of a loan?
Since no regular monthly payments are being reported to credit bureaus, your credit score may take a short-term dip. However, in the long run, since your credit history reflects an early repayment, you will be seen as a person with a good credit history.