TL;DR: having top-tier privileges lets you get ahead of your mortgage without paying fees or penalties. You can make lump sum payments any time, increase your regular payment, or do both. You get a certain amount of room each year.
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Having the option to pay off your mortgage earlier either by increasing your monthly payments or putting down lump sums at different times over the term is called your mortgage prepayment privileges. These will be listed in the terms and conditions of your mortgage agreement. There will be a percentage limit on how high you can bump up your monthly mortgage payments. As well, there is also a limit on how much you can pay in lump sums in any given year, usually expressed as a percentage of your original mortgage amount.
Typically the prepayment options are referred to as 10/10, 15/15, or 20/20. It is important to understand what these numbers mean. A 15/15 prepayment option means the borrower can increase a mortgage payment by 15 percent of the base amount, and/or make extra one-off payments any time, and the two put together must not be more than 15 percent of the original mortgage.
Benefits of using your mortgage prepayment options
For many, the term of a mortgage is a long time and a lot can happen in that time that may impact your finances. This can include getting a large sum of money like a bonus, a raise, or an inheritance. In this situation, you may want to put some extra cash towards your mortgage to help pay it off quicker. By having good prepayment options outlined in your mortgage agreement you set yourself up for any number of possibilities over the coming years.
Alternative to mortgage prepayment
Although paying your mortgage down can help save you on interest payments, you may also have other places you want to spend that extra money. For example, it may be wiser to contribute to your RRSP and reap the benefits of the tax savings. Then you can put the tax savings sum towards your mortgage. This is a fairly common tax strategy and works well for many.
Other ways to pay your mortgage off faster
Paying more per month or putting down lump sums throughout the mortgage term is not the only way to knock back your mortgage faster. Borrowers who opt for accelerated weekly or accelerated bi-weekly payments will also be able to pay a mortgage off quicker. These options can take years off a mortgage amortization and save you thousands (if not tens of thousands) of dollars in interest costs.
Example of calculating prepayment allowance
For easy math, let's say the prepayment options are 20/20, the original mortgage amount is $100,000, and the payment amount is $1,000.
Each year, there would be 20 percent of $100,000 of "room" to make extra payments, so $20,000 of prepayment allowance.
The $1,000 payment can be increased to any amount between $1,000 and $1,200 ($1000 + 20% of $1,000 = $1000 + $200 = $1,200). Suppose it was increased to $1,200/month for 1 year. This would be an extra payment of $200/month, or $2,400 over an entire year.
Then suppose a one time payment of $1,000 was made in January, and another one time payment of $5,000 was made in August. This would be a total of $6,000 of extra payments.
The $2,400 of extra payments due to the increased monthly payment, plus the $6,000 of extra payments from the one-time payments, would use $8,400 out of the total $20,000 of prepayment allowance for the year.
On the anniversary of the mortgage (the closing date), the $20,000 amount resets, and does not carry forward any unused amount from the previous mortgage year.