Why Prepayment Terms Matter

While there is no published research on this fact, the generally accepted measure in the market is that around 65% of Canadians will break their mortgage early during their lifetime. Just like nobody goes into a marriage expecting to divorce, nobody goes into a mortgage expecting they will need to break it early. In this article, we discuss some of the reasons that would result in you breaking a mortgage early and how to handle it.

If you’re currently comparing mortgage options, it’s essential to understand key terms that apply to you. In this overview, we explore what these terms mean for you if you choose to break your mortgage early.

Bona Fide Sale Clause

• Commonality
  Most mortgage lenders don’t have a bona fide sale clause. It’s typically only present with low rate product offerings.
• Explanation
  You can’t break your mortgage early for any reason other than if you are selling your home. Switching lenders for a lower rate or refinancing before your term is up would not be possible with a bona fide sale clause. Note that this restriction is only applicable during your mortgage term and you’d be able to do any of these things upon maturity.
• Consideration
  You should only consider a mortgage with a bona fide sale clause if the interest savings are substantial, meaning the rate is at least 0.15% lower than other mortgage options without this clause. Also, you’d want to confirm market interest rates are not trending downwards and your need to refinance before the end of your term is extremely unlikely.

Mortgage Payment Increase Allowance

• Commonality
  All lenders offer a payment increase allowance, with a typical range of 15-25%.
• Explanation
  Pay your mortgage off faster by increasing your regular mortgage payments up to a maximum percentage each year. The increase in your payment goes directly towards paying your mortgage principal, which reduces the amortization (how many years until your mortgage is fully paid off) and how much mortgage interest you pay in the long run.
• Consideration
  A higher allowance would only be valuable to you if you expect to experience large income increases in the near future and you intend to use a portion of that income to pay down your mortgage. Note that you have the ability to reduce your amortization period at renewal or when you first get the mortgage, which allows you to accelerate your payments without needing to do it through payment allowance increases. You’d use this benefit if you need to increase your payments during your term.

Annual Mortgage Lump Sum Allowance

• Commonality
  All lenders offer a lump sum payment allowances, with a typical range of 15-20%.
• Explanation
  Pay your mortgage off faster by making a lump sum payment of your original mortgage amount each year up to the specified percentage. This payment goes directly towards paying your mortgage principal, which reduces your amortization and how much mortgage interest you pay in the long run. For example, if you took out a $400,000 mortgage and had a 20% lump sum allowance you would be able to pay down $80,000 on your mortgage each year without penalty.
• Consideration
  A higher allowance would only be useful to you if you expect an inheritance, receive large bonuses, etc. While having the ability to consistently pay down 20% of your mortgage balance each year (as illustrated in the example above) is ideal, it’s also highly unlikely. Especially considering that you can simply save the additional income and wait until your mortgage term ends to pay down more than 20% without penalty before renewing at a smaller amount.

Mortgage Penalty Calculation Methods

• Commonality
  All lenders charge a penalty for breaking a mortgage early unless it’s an open mortgage term. While an open term can sometimes be a good idea (we explore open mortgage terms in this article), the vast majority of mortgages are closed terms as open term mortgages are expensive.
• Explanation
  Penalties are charged when you pay down more than what is allowed as per your annual lump sum allowance. Unfortunately, each lender has their own mortgage penalty calculation methodology and it’s difficult to navigate and compare effectively since your penalty would be charged at a future rate that isn’t known today. We’ve seen cases where a lender’s penalty may be 2-3x that of another lender purely based on their calculation differences. Your mortgage professional should be able to help you navigate this and weigh the benefit of a lower rate versus the potential difference in penalties.
• Consideration
  All lenders charge penalties, so you can’t avoid it. However, if you have multiple mortgage options that offer similar rates you should opt for the least punitive penalty terms amongst the offers.

The rate type also plays a big part in this. Variable rate mortgages will typically always be a 3-month interest penalty, whereas the fixed rate mortgage will be the greater of 3-months interest or the interest rate differential (which is extremely difficult to predict). A variable rate penalty is therefore easier to predict with a reasonable amount of certainty.

Charge Type

• Commonality
  Every mortgage must be registered as a standard or collateral charge mortgage. If you have a home equity line of credit (HELOC), it will always be a collateral charge.
• Explanation
  The charge type is how the lender secures your home as collateral for the mortgage they lend you. However, getting a collateral charge mortgage makes it more expensive to switch lenders for a lower rate. This is because the new lender may not cover your legal costs (typically $1,500-$2,000) to switch if it’s a collateral charge and you’d have to pay for it out of pocket.
• Consideration
  If you don’t need a HELOC and have multiple mortgage offers, opting for a standard charge would be your best bet.

Mortgage Portability

• Commonality
  Most lenders allow you to port your mortgage, but it must be approved in advance.
• Explanation
  Take your mortgage with you to your new home if you qualify for it and your closing date is within 30-45 days (depending on the lender) of the sale of your old home.
• Consideration
  A portable mortgage is best if you think it’s likely that your next home would be of equivalent or lesser value (example: downsizing or moving to a less expensive city) and you wouldn’t need a larger mortgage. The main benefit is you then avoid paying mortgage penalties (since you don’t break your mortgage) and also keep your current mortgage terms.

Assumability

• Commonality
  Most lenders allow for a mortgage to be assumed, but it must be approved in advance.
• Explanation
  Imagine being able to sell your house and your mortgage at the same time. In allowing a new borrower to “assume” your mortgage, you transfer your mortgage over to another person and avoid paying the penalty to break your mortgage. In the event you have a mortgage rate lower than the market rates, you could even make a profit if your buyers are willing to pay for a lower mortgage rate.
• Consideration
  An assumable mortgage would be valuable if rates are expected to rise and you have a large enough mortgage balance as a percentage of the home (typically 70% or more) to make it worthwhile for the buyer. In this article, we go into more detail about how to factor assumptions into your decision making process when selling or buying a property.

Bundling Mortgage Prepayment Terms For Success

The terms you get on your mortgage will vary based on the lender you go to and the mortgage product you choose. The goal shouldn’t be to try to find a mortgage product that gives you every favourable term, since you would likely end up paying a higher rate for something you likely don’t need. The goal should be to understand which of the terms are important to you and then factor those into the decision-making process as it relates to how much you’d be willing to pay for that option.

Consult with your mortgage professional to identify what terms make the most sense based on your situation and then evaluate your mortgage options holistically, looking at not just the rate but the terms that go with it.