Mortgage payments are a fact of life for homeowners, but did you know you might have the option to suspend your payments for a short period? This is often called a mortgage vacation, and you’re allowed to take a few months off from paying your mortgage if you make prepayments.
Although a mortgage vacation sounds like a great idea, there’s a catch. Interest still accrues when you’re not making payments, and that’s added to the principal. As a result, you may end up paying thousands of additional dollars in interest.
How do mortgage vacations work?
Most mortgages allow you to make a prepayment on top of the regular mortgage payment. If you make a prepayment, your financial institution may offer you a mortgage vacation. You may choose to take this type of vacation if you plan on going back to school, taking parental leave or taking a sabbatical, etc.
TD, for example, allows a mortgage vacation of up to four months, depending on the amount of your prepayment.
Let’s assume you have a $325,000 mortgage with a five-year fixed mortgage rate of 2.39% and a 25-year amortization. That means your monthly mortgage payment is $1,438. If you want to take the full four months off, you’ll need to prepay $5,752 ($1,438 x 4).
If you make a prepayment of $5,752 in the 12th month into your mortgage, your mortgage balance will be $309,614 at the end of the first year. In the following month, the interest portion of your monthly $1,438 mortgage payment will be about $613.
If you take your mortgage vacation then, your mortgage balance will continue to grow each month as interest accrues. After four months, your mortgage balance will grow by at least $2,454 ($613 x 4) and you will owe a little more than $312,068 ($309,614 + $2,454). The actual number will be slightly higher due to compounding, but it gives you an idea of how much a mortgage vacation could end up costing you.
In the event you bought mortgage life insurance or critical illness insurance, those payments still need to be made. If you pay mortgage insurance premiums or municipal tax in your mortgage, those also need to be paid.
Mortgage prepayments and penalties
Before deciding whether to take a mortgage vacation, you need to find out how much of a prepayment you’re allowed to make. Most financial institutions allow you to make a lump-sum prepayment of between 10% and 20% of the original principal amount every year without having to pay a penalty.
Another prepayment option that may be available to you is called a double-up payment, which is twice as much as your regular mortgage payment. If your usual payment is $1,438 a month, a double-up payment would be $2,876.
In both cases, your prepayment goes directly towards your principal. But first, ensure you’re allowed to make one of these types of prepayments, or you may incur a penalty.
Mortgage vacations vs. mortgage deferrals
Mortgage payment deferrals have been relied on heavily in the last few months as millions of Canadians lost their jobs or had their hours reduced due to the COVID-19 pandemic. Although the unemployment rate fell to 12.3% in June from 13.7% in May, the rate is still more than twice as high as February’s 5.6%.
Instead of potentially facing a wave of mortgage defaults, financial institutions allowed affected homeowners to defer their payments for up to six months.
According to the Canadian Bankers Association, 13 member banks have allowed 760,000 Canadians to defer their mortgage or skip a payment as of June 30, 2020. And about 90% of those who applied for deferral were approved.
A mortgage payment deferral is slightly different than a mortgage vacation. With a deferral, you aren’t required to make any prepayments ahead of time. But like a mortgage vacation, you don’t make any mortgage payments, and interest continues to accrue.
Using our example above, if you opted for a mortgage payment deferral, about $613 of interest would be added to your mortgage principal every month. Over six months, that’s nearly $3,700 in interest.
“When your payments start again, your mortgage payment might be based off the total amount you then owe to pay off your mortgage in accordance with the original payment schedule,” notes the Canada Mortgage and Housing Corporation. As a result, you should check with your financial institution to find out if there will be any changes to the amount you pay.
Skipping a mortgage payment is similar to deferral and an alternative that many financial institutions offer. TD, BMO and RBC are just a few banks that offer this option on most of their mortgage products. You can usually skip one monthly payment, up to two consecutive biweekly or semi-monthly payments, or as many as four consecutive weekly payments no more than once a year. With TD, this can only be done four times over the length of your mortgage’s amortization period.
Like a mortgage deferral and a mortgage vacation, the interest accrues and is added to the principal.
Should you take a mortgage vacation?
Mortgage vacations give you some time off from paying your mortgage, but it could end up costing thousands of dollars in additional interest despite the fact that you made prepayments in an attempt to pay off your mortgage faster.
Even if you decide to take a mortgage vacation, you still need permission from your lender. TD notes that “you must first make at least one regular mortgage payment and give us reasonable notice.”
Instead of taking a mortgage vacation, it’s better to set up an emergency fund. That money can be held in a high-interest savings account or a tax-free savings account (TFSA). With either of these options, you’ll earn interest rather than pay interest.
Using your emergency fund will allow you to cover future mortgage payments if you decide to take parental leave or go back to school.
This post has been updated.