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What You Need To Know About Mortgage Prepayment Penalties
What is prepayment?
A prepayment occurs when you pay more that you are supposed to pay according to the payment schedule that the lender gave you. When you take up a mortgage, your lender will provide you a basic payment schedule or amortization table to show when you have to repay how much. Making a payment in excess of your obligation is a prepayment. The excess will be used to reduce your outstanding loan balance.
Lenders generally do not like prepayments. The first reason is that they will suffer a “loss” from the reduction of projected interest charges as your outstanding loan has decreased. Secondly, a prepayment out of the blue can wreak havoc in recalculations of your monthly payments. The most common way that prepayment occurs is when you sell off your property and use the sales proceeds to redeem the loan. Or when you refinance your mortgage by taking the loan to another bank.
What is prepayment penalty?
This is a fee that you have to pay the bank when you prepay your loan. This can be in the form of a partial prepayment or a full prepayment via redemption. The loan facility letter which you have accepted and signed in the first place will state specifically how long a prepayment period will be and the charges involved. An example is 2% on the outstanding loan balance within 2 years of loan commencement.
Lenders often offer very attractive low mortgage rates in the initial years of a mortgage to acquire you as a customer. In some instances, the rates can be so low that the lender is actually making a loss by selling you a loan that those rates. Their strategy is to convince you to stick to them as a client when interest rates rise in the future. So it is a give and take situation where in order for you to take up a killer loan package with low initial rates, you will have to accept a prepayment period also referred to as a “lock-in” period. Because if they don’t charge you a fee for prepayment, they may very well make a loss.
How can I prepay without penalties?
This varies from bank to bank and loan to loan. It really depends on the terms of the mortgage that you signed up for. If prepayment without penalties is something of strategic importance to you, be upfront with your mortgage banker in the first place so that you will not mistakenly sign up for one with prepayment penalties. Some loans can have no partial prepayment penalties but with full prepayment penalties. But usually, the period of incurring these charges will expire after a certain period which will be stated in your contract.
It can sometimes be advantages to pay the fees if refinancing rates are available that is way below what you are paying. In that case, go for it before interest rates rise again. Waiting out the “lock-in” period before taking action can mean losing out on the opportunity to grab a killer mortgage. A prepayment penalty incurred can look like a drop in the ocean when you look at the bigger picture especially if your mortgage is a pretty big one.
Under some conditions, you can exploit redemption terms in your favour. For example, a loan has a partial redemption of 1% on the redeemed amount, while a full redemption has 1% on the full loan amount. If you have taken up a $1,000,000 loan with $233,000 outstanding, and have money to fully repay the loan, this is what you can do. Should you repay the full $233,000, you are going to incur a penalty charge of $10,000. But if you just repay $230,000 of it, you are going to incur a $2,300 charge. The smart thing to do then is to just repay $230,000 and leave the remaining $3,000 to repay in instalments. This $3,000 will then be recalculated to a new monthly instalment according to your remaining tenor. When the penalty period expires, then you will be free to fully pay it up without any headaches.
How is the “lock-in” period determined?
This is also something that depends from lender to lender and loan to loan. It would be complicated to find a loan that is so much better than the next comparable one and has zero lock-in period as well. Not impossible, just very tough. You will have to be at the right place at the right time.
It can be a tiring cat and mouse game to play with lock-in periods. If you have already committed to a lock in period, wait it out before refinancing unless something in the market comes up that blows every other loan out of the water. 2 years is a pretty fair length of time. It is not too short and not too long. Having to commit to that time frame to qualify for an attractive loan is a no-brainer. Fixed rate loans also always come with a lock-in.
On a final note, sometimes it is just not worth the hassle of having a headache over prepayment penalties when your loan size is small. It could be more worthwhile to wait out the lock-in period before redemption rather than incur the penalty charges. You get to stretch out your cash flow while buying more time to see if there are better places to park your excess cash.