What is a prepayment privilege?
Prepayment privilege is the ability to prepay a portion of the mortgage principal before it is due and without penalty. Prepayment is simply paying more than the monthly payment on the mortgage, with the extra amount applied to the principal.
Mortgages are usually paid on a monthly basis, according to an amortization schedule, and the mortgage holder profits by earning interest on the unpaid balance. When a borrower prepays a portion of the mortgage, the mortgage holder loses interest. Therefore, on many mortgages, there is a prepayment penalty.
The penalty can be substantial. In many cases, it can be up to 3 months of payments, or the interest differential of interest at the time of the prepayment minus the prevailing interest rate. Obviously, these are penalties a home buyer would like to avoid.
Types of Prepayment privileges
If you have a prepayment privilege, you can avoid these penalties. An open mortgage will have no penalties, so it carries prepayment privileges. Open mortgages generally carry a higher interest rate than closed mortgages, however.
Other mortgages may have a limited annual prepayment privilege. For instance, a mortgage may provide that 15% of the principal can be paid annually without penalty.
Buyer A has a $200,000 mortgage with a 5% interest rate and a 15% annual prepayment privilege. In the first year of the mortgage, Buyer A will be able to pay roughly $30,000 or 15% of the mortgage principal in addition to monthly payments.
These mortgages are good for people who have seen an increase in income since the mortgage was issued, and are able to add extra to their mortgage payment each month. They are also good for clients who like to apply an annual lump sum payment to their mortgage, such as a tax refund.
For those who have no desire, nor the means to prepay any portion of the principal during the term of the mortgage, they may consider looking at mortgages with limited prepayment privileges. There is a good chance they can obtain a better mortgage rate without having to pay for unneeded, larger prepayment privileges.
At Capital Mortgages, finding the right mortgage for you is important. We can discuss your current financial situation, as well as your future financial plans, to determine whether prepayment privileges are a mortgage term that is important to you.