This is a very important feature to have in your mortgage if it is a closed mortgage. If your mortgage is open you can pay in part, or in full the balance outstanding on the mortgage at any time without penalty. If, on the other hand, you have a closed mortgage that does not have any prepayment privileges, you are locked in for the term of the mortgage (three years, for example) without the privilege of prepaying without penalty.
You may therefore wish to have a mortgage that, although it is called a “closed” mortgage, is in fact partly open and partly closed. It permits prepayment at certain stages and in a certain manner, but not at other times. For example, you may be permitted to make a prepayment of between 10 and 20 per cent annually on the principal or original amount outstanding, depending on the terms of your mortgage. This could be made once a year on the anniversary date of the mortgage, or at any time during that year, depending on the terms of your mortgage.
Another variation would also give you the option of increasing the amount of your monthly payment by 10 to 20 per cent or more once a year, or at any time in the year. You can see the incredible difference this would make in terms of saving on interest and reducing the amortization period. Every time a prepayment is made or you increase your monthly payments, the balance owing, and thus the monthly cost of interest, is reduced.
The net effect is that a larger portion of each payment will be applied toward the principal, since monthly (or otherwise agreed-upon) payments usually remain the same. Make sure that you completely understand your prepayment options, as they could save you a lot of money. There is a considerable variance between lenders with regard to mortgage terms, so make sure you “comparison shop”.
For example, you may want to have these options: to pay up to 20 per cent any time in that year rather than waiting for the anniversary date of the mortgage, to have the pre-payment amount based on the original amount of the mortgage rather than on the outstanding principal at the time, and to increase your monthly payments by up to 20 per cent at any time in the year rather than only on the anniversary date. In other words, you may want to have it all! Make sure that the mortgage commitment letter you receive from the lender clearly spells out the options that you want.
A lender may be prepared to give you a “side letter” which confirms a modified term arrangement. For example, the lender may have pre-printed mortgage documents and a standard policy that is not as attractive an arrangement for you. The form might say “10 per cent pre-payment annually”, but the side letter could say you are permitted to pay up to 15 or 20 per cent. If you negotiate effectively, you may be able to get them to modify the terms in order to remain competitive and get your business. On the other hand, their policy may not permit a modification of the standard terms.
If you are buying a home to live in, you probably want to have as many pre-payment options as possible, especially if you know you will have extra money available from various sources. This will save you a lot of interest over time.
On the other hand, if you are buying real estate strictly for investment purposes, you may have a policy of not paying down the principal outside of the normal payments. Presumably you would be debt-servicing all expenses, including mortgage-related costs from your rental revenue. This would preserve your cash and make it available for other purposes such as other real estate investments, for example. In this scenario, you would presumably be counting on equity appreciation over time.
