This article is updated from a previous version.
Mortgages take a long time to pay off because for the first decade or so, most of your monthly payments go toward interest. It’s a little soul-crushing if you spend too long thinking about it.
But there’s one day in the calendar year where you can make a lump sum payment that goes directly toward the principal, potentially shaving off a ton of time off the life of your mortgage.
It usually happens on your ‘mortgage anniversary,’ or the date you locked into your mortgage agreement.
Some lenders offer this extra payment option, but it’s not open to everyone. Here’s when you should take advantage of this hallowed day — and when you shouldn’t.
It won’t make your payments smaller, but that’s not the point
Unfortunately, making a lump sum payment at once won’t lower your monthly payments because you’re on an amortization schedule (the length of time it’ll take to pay off both the interest and principal on your loan). However, what it will do is change the distribution going towards the principal and interest — and the distribution of your payments will change immediately.
“You end up lowering the balance and the amount of interest over time and you’re able to pay the mortgage off in an accelerated time period,” says Fred Babbie, a mortgage broker at SafeBridge Financial.
Breaking down the payments
Mortgage lenders that let borrowers to make lump sum payments usually allow a maximum of 20% a year. Say you’ve qualified for a $400,000 mortgage at a rate of 5.14% on a 25-year amortization schedule. That means your monthly payments would be $2,358.40.
In this scenario, a 20% lump sum payment would be $80,000. If a borrower were to make that payment every year, they could conceivably pay off their mortgage before the five-year term is even up. Not only would you have paid off your mortgage, you’d also pay substantially less interest: only $16,790.84 versus $96,308.20.
Exciting, right? What if you received a financial windfall (an inheritance, for instance). Does that mean you’d be able to wipe off years off your mortgage in one day?
You could, but you’ll probably have to pay some hefty penalties if you pay off your mortgage early: with variable-rate mortgages, the most common penalty is three months’ worth of interest charges.
Technically, it’s a privilege to be able to make an extra payment on your mortgage (yes, it’s a privilege to give banks more of your money — more on that later).
If you want the ability to mark your mortgage anniversary with a bonus payment, you have to ask for the option when you’re negotiating your mortgage agreement.
“Some banks will allow you to pay as much as 20% as little as 5%,” says Babbie. “It’s not standard across the board. It depends on the product.”
It’s also important to read and understand your lender’s guidelines around prepayment privileges, he adds.
What kind of lenders offer this an option?
Most lenders will allow you to negotiate extra payment privileges, but they’re more commonly offered by the big banks. In addition to lump sum payments, you may have the option of increasing monthly payments by 20%. Again, this can save you a lot of interest over time.
Lenders rely on the steady stream of income that homeowners supply: giving people the freedom to break contracts early would quickly rack up administrative costs and make banks less profitable. But since banks offer lots of different products and services, they can offset the potential losses.
Plus, people want flexibility, so it’s an effective way to attract new clients and get even more business.
“A lot of what banks offer, it’s not just mortgages — they offer numerous other products as well, like lines of credit,” says Babbie. “Plus, the more somebody pays off on their home, they use it to take out a home equity line of credit, so other ancillary business … will come from there.”
Private, sub-prime lenders are the least likely to offer extra payments as an option, says Babbie.
When should you not make extra payments?
Traditionally, paying your mortgage off early hasn’t always been worth it, as the amount of interest generated on investments could be worth more than what you lose paying interest on your mortgage.
However, the one-two punch of the Bank of Canada’s current trend of hiking interest rates, and middling investment returns due to a turbulent economy undergoing high inflation might inspire many to pay down whatever they can. It’s worth watching the market and keeping an eye on interest rates to figure out what’s best for your situation.
Instead, where you will likely want to forgo making extra payments towards your mortgage is if you have other forms of high-interest debt.
For example, if you have credit card debt, tackle that first.
“If you have unsecured credit, always pay it off first. Not many investments are going to make 19%,” says Babbie, referring to the typical interest rate charged by credit card lenders.
“Otherwise, you’re saving on one end and spending on the other.”
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