First-Time Homebuyers: Beware Prepayment Penalties!

We’ve all heard the term ‘mortgage,’ some might even know that as a standard, you’re allowed to pay a lump sum of 15 percent per term on the original amount outstanding. But what if you manage to penny-pinch a little extra this year and decide to pay more than that? Are you aware that the difference (anything over the 15 percent) is subject to a ‘prepayment penalty’?

The breakdown

When a borrower (you) seeks a mortgage from a lender (most commonly the bank), you agree to pay a certain percentage in interest (sometimes referred to as mortgage coupon rate). This is of the utmost importance to the bank, because it guarantees that they will make gains on the money they’ve fronted you and compensate them for any risk of payback. If you repay the mortgage in a shorter time frame then you originally signed for, the bank would miss out on the opportunity to collect interest for that period; hence prepayment penalty fees. Basically, the prepayment penalty ensures that the bank collects the interest you agreed to pay them when you made that contract (which is why savvy investors will recommend putting more down when possible).

Open and closed mortgages

With open mortgages, the borrower is capable of exceeding the set payment at any time – and open mortgage is entirely ‘open’ to prepayment at any time. However, open mortgages are generally used for shorter term mortgages like improvement loans.

Typically, improvement loans are agreements based around shorter repayment periods with higher interest (or coupon) rates on the mortgage, which compensates the lender for the risk of payback. Unlike other prepayment penalties, in open mortgages, the risk of prepayment before the end of term is secured in the interest rate. The bottom line: the bank will always achieve the minimum desired profit. What’s the point in having an open mortgage? Well, according to Darryl D. Bellwood, Director of Commercial Lending in the Commercial Origination Group at First National Financial LP, “The lender still achieves their desired yield on the mortgage while the borrower still has the option to pay out the loan at any time.”

Closed mortgages

If your head isn’t hurting yet, there are two different types of closed mortgages to wrap that brain around.

Before explaining how these work, it is important to note that the reason many people will opt for longer term-mortgages that restrict how much they can pay and when is because interest rates are typically lower on these types of mortgages. In some (but rare) cases the mortgage cannot be prepaid at all, and is fully closed from the start to the end of the term. In this case, the bank will not accept a compensation for prepayment to allow the borrower to pay out the mortgage because the borrower is locked until the end of term. Once the term ends, the borrower can either pay out the mortgage or enter into a new term.

Photo by Nicola Betts

The first type of closed mortgage is the one mentioned above, it’s just a mortgage that cannot be prepaid at any time. The second enables early repayment of the loan in full with a penalty. The rationale behind this is that when the lender agrees to front that money, they do so with the intent of obtaining a set return or profit on the mortgage.

Prepayment penalties are difficult to calculate and depend heavily on the remaining mortgage factors like set interest rate, outstanding balance and time remaining. A general outline of how it is calculated, specified by Bellwood is as follows:

“Three months interest is the lowest cost penalty. It is usually calculated using the outstanding balance on the mortgage at the time of the prepayment and is calculated by multiplying the coupon rate of the mortgage divided by 12 and multiplied by three.”

Another type of prepayment penalty is the Interest rate differential (IRD), which is the most common penalty related to paying out a mortgage early. Based on a present value calculation, meaning, what is left to be paid out, these penalties can be quite costly and can in some cases end up yielding borrowers “unpalatable” costs.

Defeasance is the third and last, more expensive penalty because there is usually a third-party handler that manages the payout, increasing fees associated with the process. It calculates the interest that is left to be paid in every payment individually, in addition to each payment there is a last percentage calculated from the payment as a whole.

First-Time homebuyers, the best thing to do is to read through and make sure you fully understand the details of your contract with the lender and consider all options to ensure you’re selecting the most suitable one for you. Since it is cheaper to abide by the original contract, it’s advised to avoid these penalties in all.