The benefits and pitfalls of mortgage prepayments

This article has been updated from a previous version.

Prepayment privileges allow you to pay off your home loan at a faster rate — provided, of course, that it’s included in your mortgage agreement. Should you choose to do so without this inclusion, you may face substantial financial penalties.

As many now realize, mortgage prepayments — which are any amount you pay in addition to your regular payment — will help reduce the overall length of time you hold a mortgage. Even small prepayment amounts can have a big impact on your overall home cost. But how do you know when you can and can’t pay ahead?

How do mortgage prepayments work?

Depending on the lender’s terms, prepayments can be made in lump sums, through regular installments, or both. In any case, the mortgage prepayment is deducted from the principal balance remaining on the loan.

The prepayment will not necessarily change the amount of a regular monthly (or weekly/biweekly) payment. However, it will decrease the principal and reduce the overall amount of interest paid to the lender.

How much can you prepay on a mortgage?

It's not uncommon for some banks to allow between 10 to 20 per cent in prepayment privileges payable in a lump sum, payment double-up options, or regularly scheduled payments.

Some even extend a no-penalty prepayment for customers to bump up monthly payments up to 25 per cent each year or make a lump sum payment totalling up to a quarter of the original principal.

Mortgages with such prepayment features are especially beneficial to homeowners who have seen an increase in income since their mortgage was issued or for those who want to use a hefty income tax refund, or other financial windfall, to pay down more on their mortgage without penalty.

When do prepayment penalties apply?

Other prepayment scenarios are not as rosy. There are penalties levied, some quite heavy if you make prepayments without prior written approval from your lender.

Mortgage companies function on the interest they earn until mortgages mature. If a customer wants to pay off a mortgage before its due date or in a fashion not agreed to beforehand, it's almost standard practice for a lender to issue a prepayment penalty.

How is a prepayment fee calculated?

While the fee charged can be a basic three months’ interest based on the existing mortgage, especially with variable rate mortgages, there are other ways lenders will arrive at a penalty for fixed-rate products.

Many choose to use the interest rate differential (IRD), which is the difference between how much a client would pay with the original interest rate and how much would be paid based on the interest rate that the lender offers at the moment.

The lender is essentially trying to recoup the lost interest using the IRD. It is important to note that lenders will differ in the way they calculate the IRD penalty.

It's also common practice for lenders to post up-to-date rates on their websites so customers can calculate or estimate their own potential prepayment penalties. Most lenders will choose the greater amount between a 90-day interest charge or IRD for breaking the mortgage contract for a fixed-rate mortgage prior to maturity.

But the shrewd homeowner may still choose to endure a prepayment penalty to accept a better rate at a competing lender after comparing mortgage rates elsewhere. Of course, the overall savings with the new mortgage and the total interest cost reduction should be justified before the move is made.