Prepayment Strategy Before Breaking Your Mortgage

RefinancePro.club

Reducing Your Balance Before Breaking: A Strategy to Minimize the Penalty

When a Quebec borrower considers breaking their mortgage before term, the prepayment penalty is often the most significant cost involved. Few homeowners realize that it is possible to substantially reduce this penalty by using the prepayment privileges built into their mortgage contract before initiating the break. This strategy relies on a simple principle: the penalty is calculated on the remaining balance, so a lower balance means a lower penalty.

Understanding Prepayment Privileges

Nearly all mortgage contracts in Canada include prepayment clauses that allow the borrower to make a lump-sum payment each year without penalty. This privilege typically ranges between 10% and 20% of the original loan amount. For example, on a $400,000 mortgage, a 15% privilege allows a prepayment of $60,000 per year. Some lenders also offer the option to double regular payments or increase the monthly payment by a given percentage. These options are distinct from full repayment, which triggers the penalty.

Prepayment Privilege: A contractual clause in a mortgage agreement that allows the borrower to repay a portion of the principal (typically 10% to 20% of the original amount per year) without incurring a penalty. This privilege is separate from full loan repayment, which constitutes a contract break and triggers a penalty.

How Reducing the Balance Affects the Penalty

The prepayment penalty for a fixed-rate mortgage is the greater of two amounts: three months' interest or the interest rate differential (IRD). In both cases, the calculation is based on the mortgage balance at the time of the break. By reducing this balance through permitted prepayments, the borrower directly lowers the base on which the penalty is calculated. Consider a concrete example: a borrower with a $350,000 balance at a fixed rate of 5.25%, with 30 months remaining on the term and an IRD of 1.50%, would face an IRD penalty of approximately $13,125. If they make a $50,000 prepayment before the break, the balance drops to $300,000 and the IRD penalty decreases to approximately $11,250, a savings of $1,875.

Steps to Apply This Strategy Effectively

Check your contractual privileges: Review your mortgage agreement for the maximum prepayment amount allowed, eligible dates, and conditions (notice period, minimum amount). If you have already used part of your privilege this year, calculate the remaining available amount.
Obtain a penalty statement from your lender: Ask your current lender for an official penalty statement before and after the planned prepayment. This will allow you to quantify the exact savings. The statement will indicate the calculation method used (three months' interest or IRD).
Evaluate the source of funds: Déterminé where the prepayment funds will come from: personal savings, TFSA, tax refund, or line of credit. If you are borrowing to make the payment, calculate the net cost accounting for interest paid on the temporary loan.
Plan the timeline with your broker: Work with your AMF-certified mortgage broker to coordinate the timing of the prepayment and the contract break. The broker will ensure contractual deadlines are met and the entire operation is optimized.
Make the prepayment then proceed with the break: Make the maximum prepayment, wait for confirmation from the lender that the balance has been adjusted, then initiate the break process. The notary in Quebec will handle the discharge of the existing mortgage and the registration of the new mortgage if you are transferring to another lender.

Frequently Asked Questions

How do prepayments reduce the mortgage penalty?

The prepayment penalty is calculated on the remaining mortgage balance. By making a lump-sum payment allowed under your contract (typically 10% to 20% of the original loan per year), you reduce the principal on which the penalty is applied. For example, a $30,000 prepayment on a $300,000 balance brings the calculation base down to $270,000, proportionally reducing both the three-month interest penalty and the IRD.

What are typical prepayment privileges in Canada?

Most Canadian mortgages offer an annual prepayment privilege of 10% to 20% of the original loan amount, penalty-free. Some lenders also allow borrowers to double their regular payments. Exact terms vary by lender and contract type. Check your mortgage agreement to know your specific rights.

When should I make the prepayment relative to the break?

Ideally, make the maximum allowable prepayment before requesting the contract break. Some lenders require a waiting period between a prepayment and full repayment. Check your contract terms and plan with your AMF-certified mortgage broker to optimize the timing.

Does this strategy work better for fixed or variable rates?

It is especially effective for fixed-rate mortgages because the IRD penalty can be very high. For a variable-rate mortgage, the penalty is typically limited to three months' interest, making it already more modest. That said, reducing the balance before breaking lowers the penalty in both cases.

Can I use my line of credit to make the prepayment?

Technically yes, but this strategy is only profitable if the borrowing cost on the line of credit is lower than the savings on the penalty. It is necessary to calculate the net cost including interest paid on the line during the holding period. A mortgage broker can help déterminé whether this approach is advantageous in your situation.