Using Prepayment Privilege to Reduce Your Mortgage Penalty

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Using Prepayment Privilege to Reduce Your Penalty

When a borrower is considering breaking their mortgage before the end of the term, the penalty can represent thousands or even tens of thousands of dollars. However, a simple and legal strategy often allows for a significant reduction of this cost: using your prepayment privilege before proceeding with the break. This approach is particularly relevant for fixed-rate mortgages where the interest rate differential (IRD) produces high penalties.

How the Prepayment Privilege Works

Virtually all closed fixed-rate mortgage contracts in Canada include an annual prepayment privilege. This privilege authorizes you to repay an additional percentage of your loan without penalty, typically between 10% and 25% of the original amount. This privilege generally resets on each anniversary date of the mortgage contract. Some lenders also offer the option of increasing your regular payments, which constitutes another form of prepayment.

The Step-by-Step Strategy

Obtain the exact penalty calculation: Contact your lender to request the exact penalty amount at the time you are considering the break. This calculation is provided at no charge. Also ask for the IRD calculation détails.
Verify your privilege conditions: Consult your mortgage contract to déterminé the authorized prepayment percentage, whether it is based on the original amount or current balance, and the reset anniversary date.
Calculate the potential savings: If your privilege is 20% and your balance is $350,000, a $70,000 repayment reduces the balance to $280,000. If the IRD was 2% per year over 3 remaining years, the penalty drops from $21,000 ($350,000 x 2% x 3) to $16,800 ($280,000 x 2% x 3), a saving of $4,200.
Make the prepayment: Proceed with the prepayment according to the terms of your contract. Ensure you respect any delays required by your lender before proceeding with the break.
Proceed with the break after prepayment: Once the prepayment is made and the required delay observed, proceed with breaking the mortgage. The penalty will be calculated on the new reduced balance.

Detailed Numerical Example

Consider the case of Marie, a homeowner in Laval with a $425,000 mortgage at a fixed rate of 4.75% on a 5-year term. After 2 years, she has 3 years remaining and her balance is $390,000. She wishes to break to obtain a 3.50% rate. Her lender calculates an IRD of 1.25% (4.75% - 3.50% for a 3-year term). Without prepayment, the IRD penalty would be approximately $14,625 ($390,000 x 1.25% x 3). Marie has a 20% privilege on the original amount, or $85,000. After repayment, the balance drops to $305,000. The new IRD penalty is approximately $11,437 ($305,000 x 1.25% x 3). The saving is $3,188.

Important Points to Consider

Check if your annual privilege has already been partially used this year. Only the remaining privilege amount can be applied.
If your contract anniversary date is approaching, it may be advantageous to wait to benefit from a new prepayment privilege.
The amount used for prepayment is not lost: it reduces your mortgage debt and you save future interest on that amount.
This strategy is more effective when the penalty is calculated by IRD. If the penalty is 3 months' interest, the savings are proportionally smaller.
An AMF-certified mortgage broker can help you optimize the timing of this operation and coordinate refinancing with the new lender.

This strategy is perfectly legal and constitutes a right provided in your mortgage contract. It is recognized by lenders and by regulation. The LDPSF in Quebec requires the broker to inform you of all options to minimize your costs, including using the prepayment privilege before a contract break.

Frequently Asked Questions

What is a prepayment privilege?

It is a clause in your mortgage contract that allows you to repay an additional percentage of your balance each year without paying a penalty. This percentage generally varies between 10% and 25% depending on the lender and mortgage product. It resets on each contract anniversary date.

How does the privilege reduce the penalty?

The penalty is calculated on your mortgage balance at the time of the break. By making a prepayment before breaking, you reduce that balance. Since both the IRD and even the 3 months' interest are proportional to the balance, the penalty decreases accordingly.

Do I need to wait for the anniversary date to use my privilege?

Yes, the privilege resets on your mortgage contract anniversary date. If you have already used your privilege this year, you will need to wait for the following year for a new payment. Plan your mortgage break considering this date.

Is the privilege based on the original amount or current balance?

This depends on the lender. Some calculate the privilege on the original loan amount (more advantageous), while others base it on the current balance. Check the exact terms in your mortgage contract or ask your lender.

Can I use my privilege and break on the same day?

Technically yes, but some lenders require a delay between the prepayment and the contract break. Check with your lender if there are timing restrictions. In practice, making the prepayment a few days before the break is recommended.

Does this strategy work with all lenders?

Yes, the strategy works with all lenders that offer a prepayment privilege, which includes the vast majority of mortgage contracts in Canada. However, effectiveness varies depending on the privilege amount allowed and the penalty calculation method.