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The ABCs of Mortgages
How to Pay Your Mortgage Off Faster
Any additional payment you make on your mortgage (also called pre-payment) will save you a lot of money in interest. Every normal payment you make consists of principal and interest. The interest portion of your payment is determined by the outstanding balance of your mortgage. As the outstanding balance diminishes, less of your payment goes towards interest and more comes off the balance.
Example – Principal vs. Interest
| Mortgage balance | Rate | If the payment is | Amount applied to principal | Amount applied to interest | ||
|---|---|---|---|---|---|---|
| $150,000 | 6.45% | $1,000 | = | $205 | + | $795 |
| $100,000 | 6.45% | $1,000 | = | $465 | + | $535 |
| $50,000 | 6.45% | $1,000 | = | $730 | + | $270 |
The faster you reduce the outstanding balance on your mortgage, the more you will save in interest charges. Since pre-payment policies vary between institutions and types of mortgages, you should consult your mortgage agreement to fully understand the pre-payment options that may be available to you. Some ways to minimize your mortgage costs are:
- Accelerated bi-weekly payment option
- Keeping the same payments if you renew at lower rates
- Increasing the amount of your payments
- Making lump-sum payments
- Paying extra on your payment dates
Accelerated bi-weekly payment option
A good way to shorten your amortization may be to choose the accelerated bi-weekly payment option. This allows you to pay half of your monthly payment every two weeks. By doing this, you end up making the equivalent of one extra monthly payment a year. To see how this works, see the following example.
Example: Accelerated bi–weekly payment option
John pays $1,000 per month for his mortgage. Since he makes this payment 12 times a year, his payments total $12,000 at the end of the year.
Let's assume that John decides to make his payments every two weeks. His payments will be $500 every two weeks ($1,000 ÷ 2) and he will make 26 payments (52 weeks ÷ 2) for a total of $13,000 at the end of the year.
The following example illustrates how much you can save in interest charges if you choose the accelerated bi-weekly payment option, assuming your mortgage is $150,000, at 6.45 per cent, amortized over 25 years.
Example – Accelerated bi-weekly payment option
| Monthly | Accelerated bi-weekly | |
|---|---|---|
| Payment | $1,000 | $500 |
| Amortization | 25 years | 22.58 years |
| Interest paid | $150,059.80 | $120,648.46 |
| Interest saved | -- | $ 29,411.34 |
Similar interest savings can also be obtained with the accelerated weekly payment option. If John decides to make his payments every week, his payment will be $250 every week ($1,000 ÷ 4). He will make 52 payments (52 weeks) for a total of $13,000 at the end of the year.
Keeping the same payments if you renew at lower rates
At the end of your term, when you renew or re-negotiate your mortgage, you may be able to obtain a lower interest rate, which will reduce your future payments.
An easy way to accelerate your mortgage payments is to maintain the same payments you were making during the previous term. The difference between your previous payments and your current (lower) payments will be applied to the principal, to reduce your mortgage balance and help you pay your mortgage down faster.
This is one of the easiest ways to pre-pay your mortgage, since it does not affect your budget and spending habits (you accelerate your mortgage payments, while continuing to make the payments you were accustomed to making during the previous term).
The following example shows how your new, lower interest rate allows you to make pre-payments of $200 per month, while keeping the same payment you had during the previous term.
Example – Keeping the same payments if you renew at lower rates
| Previous term | Current term | |
|---|---|---|
| Interest rate Monthly payment Minimum payment required (given mortgage interest rate) |
7.5% $1,100 $1,100 |
5.5% $1,100 $900 |
| Difference - additional amount applied directly to the principal to further reduce your mortgage balance | $0 | $200 |
Increasing the amount of your payments
Most lending institutions will allow you to increase the amount of your mortgage payments. Some institutions allow an increase once a year; others, only once per term.
The amount of increase allowed varies by lending institution and by type of mortgage, and can be as high as 25 per cent.
For example: If your current mortgage payment is $1,000 per month, you may be able to increase it by $200 to $1,200 per month ($1,000 × 20% = $200). The extra portion of the payment is applied as principal against the outstanding balance of your mortgage and accelerates your mortgage repayment.
The disadvantage is that this increase may be permanent (depending on the lending institution), and it may be difficult to bring your payments back to their original amount. You should therefore make sure that you can handle new, higher payments until the end of your mortgage term.
Making lump-sum payments
Most lending institutions will allow you to make lump-sum payments against the principal. Since these amounts are applied to the principal only, they reduce the outstanding balance of your mortgage.
The amounts allowed vary by lending institution and by type of mortgage and can be up to 20 per cent, and sometimes more, of the original amount of your mortgage. If you borrowed $100,000 originally and your institution allows you to make lump-sum payments of up to 15 per cent, you will be allowed to pay up to $15,000 extra every year.
You can usually only do this once a year, and your institution generally determines when it can be done.
This pre-payment option is not cumulative. In other words, if you did not make additional payments on your mortgage this year, you will not be able to accumulate the percentage of pre-payment allowed and double your pre-payment next year. In the example provided, you would not be able to double your payment from $15,000 to $30,000, because you did not make a payment last year.
Paying extra on your payment dates
Most lenders will allow you to make additional payments on your mortgage, sometimes referred to as "double-up" payments. These extra amounts are applied to the principal only and reduce your mortgage balance, which helps you pay your mortgage off faster.
Although there are some limitations, which vary by institution and by type of mortgage, you can generally double your normal mortgage payment on any payment date. Some lenders may let you decide how much extra you want to pay (i.e., they may allow "partial doubling") and when you can pay it. Your lender might even agree to automatically withdraw the money for the extra payment from your account each payment date.
With double-up payments, the limits on your payment increases are not as strict as with the pre-payment option outlined earlier (100 per cent rather than up to 25 per cent), and you may stop making double payments at any time.
Some institutions, however, may deduct your total extra payments from the amount of the lump-sum payment you are allowed to make (see “Making lump-sum payments”, above).
For example, let's assume that your monthly payments on your original $100,000 mortgage are $1,000 and that you decide to make an extra $500 payment each payment date, and that your institution allows "partial doubling" of the payment amount. Let's also assume that your institution allows you to make lump-sum payments of 15 per cent of your original mortgage every year. Here is how some institutions will determine your maximum lump-sum amount for a given year.
Example – Maximum lump-sum payment allowed
× 15%
Minus:
Extra payments ($500 × 12)
Maximum lump-sum payment allowed
$15,000
−
$6,000
$9,000
When shopping around, it is important to ask the lender what the prepayment options and conditions are, so you can determine the best prepayment option for you.
