Pre-Payments, Penalties and Ports
If there is one thing you may have learned so far from my social media and blog posts, it is that not all mortgages are created equal!
There are quite a few different options and plans you could choose to suit your lifestyle and financial goals so I thought today I would touch on the most common features that most people overlook when choosing a mortgage product. It is easy to focus on the interest rate as the most important factor, but rates are not always the biggest consideration for financial cost associated with a mortgage.
Lenders like to have a certain amount of guaranteed income each year so they can invest accordingly in more mortgages, when signing into a closed mortgage contract they are counting on a certain amount of interest to be paid over the term of your mortgage with them. Which is why breaking your term with them early typically incurs penalties. Breaking your term by selling your home and paying off your mortgage for example means the lender will now make less money off your mortgage than they had hoped. Lenders, however, do understand that life happens and that not everyone wants to be paying a mortgage for 25 years so there are a number of features that apply to different mortgage products to make it easier for you to minimize your risk of a large penalty.
Before we delve further into it, just a quick explanation of term and amortization. The Amortization period (typically 25 or 30 years) is the length of time it will take you to pay off the mortgage if you only ever make the minimum required payment. A term is the length of time you are locked into one specific type of mortgage product and you will go through many different terms in the length of your mortgage. Terms can be as short as 6 months, or as long as 10 years but the most common is a 5 year term.
A pre-payment privilege is the opportunity to pay down more of your mortgage faster without risk of a penalty. Lenders understand that not everyone wants to be locked into a mortgage for 25 or 30 years so they offer the option to pay extra on the mortgage in order to pay it out faster. Paying extra won't reduce your monthly payments, instead it decreases the length of time you will have a mortgage. So for example, paying an extra $500 a month may mean that it will only take you 15 years to pay off the mortgage rather than 25. Pre-payment privileges are very different from lender to lender and product to product. They typically range from 10% to 20% of the principle loan per year. Some lenders will allow you to make payments in lump sums at any time through-out the year, some will only allow it once per year. Some allow you to increase your payments through-out the year and others will let you do it once. Some won't allow payment increases at all, but only lump sum payments and others allow you to do a combination of the 2 options. Figuring out if this is an important factor for you to consider greatly depends on your priorities. If paying off your mortgage sooner is not a concern, then this feature may not be important to you to consider when choosing a mortgage product. You may also want to consider what is a reasonable amount per year you think you could feasibly afford to pay off as extra payments if that is your plan. The industry leading pre-payment privilege is 20% of the original borrowed amount per year in a combination of increased payments or lump sum payments. On a mortgage of $300,000, that means you could pay up to $60,000 extra each year without penalty - if you did that for 5 years you could be mortgage free by the end of the first term. However, coming up with an extra $60k per year ($5,000/month) is not exactly feasible for most buyers therefore having this high of a pre-payment privilege may not be a major concern to most people.
That said, another advantage to a higher pre-payment privilege means if you do break your mortgage and pay it out early, you will only be charged the penalty on the amount after they consider your privilege amount. So the higher the pre-payment privilege the lower your penalty essentially.
When you are signed into a closed term mortgage you will be subject to a payout penalty if you break that term. This can happen by selling your home, refinancing, payout out an ex-spouse in a divorce etc.
Penalties are calculated either one of 2 ways. The first is '3 months interest' where they charge you the equivalent of 3 months interest payments. The second is what is known as an Interest Rate Differential. In this calculation, they take the difference between your interest rate and the current going rate then calculate that over the remaining balance of the mortgage over the remainder of the mortgage term.
In a fixed rate mortgage product you will pay whichever of these 2 penalties is higher. In a variable rate mortgage product you will pay the 3 months interest method.
It is important to note that there are some very basic mortgage products which charge a flat % fee for breaking the term early and do not use either of the above described methods regardless of whether it is in a variable.
To avoid payout penalties entirely you can opt for an open mortgage product where you can payout the full amount at any time. Open products however, come with a much higher price tag as interest rates are quite high. I would typically only recommend an open mortgage if you will be in the mortgage for a short period of time, usually less than 6 months. Often the payout penalty of 3 months interest on a variable rate mortgage is less than what the increase is you will pay in interest on an open mortgage if you go past around the 4 month mark. Porting
Portability is one feature that can also help minimize your payout penalty if you need to sell and move part way through your term. Porting a mortgage means that you can take your mortgage with you to a new house if you sell and move which means you won't necessarily need to pay any penalties. If you are porting and decreasing the size of your mortgage you will pay a penalty on the difference between the old mortgage and the new, but if that difference is less than your pre-payment privilege you could get away with not having any penalty at all.
If you are porting and increasing the size of your mortgage they will do a blended interest rate combining your old rate and the new current rate to give you your new interest rate. Don't count on porting though as a fall back plan for saving the penalty. Porting only works if the new property appeals to the lender and there are occasionally debt servicing issues to consider, especially if the new property is worth quite a bit more. For example, you may not be able to afford the new property within the remaining parameters of the current mortgage.
Also, lenders will not always lend on every type of property. If your current home is a condo in the city and you are looking to purchase a farm for example, your existing lender may not be able to cover the farm ruling out porting as an option.
The bottom line
There are many features and options to discuss when choosing a mortgage that suits you and your family so it is important to have the discussion about future plans with your favorite broker before jumping into a mortgage contract. As time goes on, your needs may change for what you may want/need from a mortgage so it is also important to ensure you are having the discussion at renewal time as well to make sure you choose the right path forward each and every time you sign into a new term. You are welcome to change the type of mortgage, lenders etc at every renewal so it is a good time to do a finance check and ask yourself a few questions.
- will we be moving in the next 5 years?
- are we considering buying additional properties?
- will we keep this property as a rental if we do?
- are we considering doing major renovations to our home?
- will we need extra money for child's tuition, travel etc. in the near future?
- are we better off paying down our mortgage or investing our savings?
There are tons of factors that will impact the type of mortgage you choose through-out your lifetime and you are certainly not expected to foresee most of them but with a little planning and a good broker on your side you can hopefully mitigate some of the risks along the way.
As always, if you have any questions give me a call at 780-720-4034