Why prepayments are so powerful
In the early years of a mortgage, most of each payment is interest. On a $400,000 mortgage at 4.50%, the first monthly payment of $2,213.89 includes about $1,486 of interest and only about $728 of principal. Your balance barely moves.
An extra payment skips the interest entirely. Every dollar goes to principal, and that dollar never accrues interest again. Do it early and it saves you interest for every remaining year of the amortization.
Worked example: $400,000 at 4.50% over 25 years
Without prepaying, you'll pay about $264,168 in interest.
| Strategy | Paid off in | Interest saved |
|---|---|---|
| $200 extra a month | 21 yrs 6 mos | $41,746 |
| $5,000 lump sum each year | 19 yrs | $70,811 |
| Both | 17 yrs | $93,374 |
Combining the two saves more than $93,000 and frees you from mortgage payments eight years sooner.
Know your prepayment privileges
Closed mortgages limit how much you can prepay each year without a penalty. The limits are written into your mortgage contract, and they vary widely:
- Annual lump sum: commonly 10% to 20% of the original principal, once per mortgage year. Some lenders allow several smaller payments that add up to the limit.
- Payment increase: commonly 10% to 100% of your regular payment, once per year.
- Double-up payments: some lenders let you pay double on any payment date.
- Use it or lose it: most privileges don't carry over. If you don't use this year's 15%, you can't make it 30% next year.
Anything beyond your privileges triggers a prepayment penalty, so check before sending a large payment. Open mortgages allow unlimited prepayment, but charge a higher rate for that freedom.
Decoder ring: the "free" accelerated payment
Switching to accelerated bi-weekly payments is a form of prepayment you'll barely notice. It works out to one extra monthly payment a year. See it on the payment calculator.
Prepay or invest?
A prepayment earns a guaranteed, tax-free return equal to your mortgage rate. Whether that beats investing depends on what else you'd do with the money:
- Prepaying is risk-free and guaranteed. Paying down a 4.50% mortgage is like earning 4.50% after tax.
- A TFSA grows tax-free, and its contribution room comes back the year after you withdraw. That makes it a flexible emergency backstop as well as an investment.
- An RRSP gives you a tax deduction now. Putting the resulting refund on your mortgage is a classic way to do both.
- Higher-interest debt, such as credit cards or car loans, should usually come first.
One more consideration: money you prepay is hard to get back. You'd have to refinance or use a HELOC, which means qualifying again. Keep an emergency fund before you get aggressive with prepayments. This is general information, not advice for your situation. A fee-only financial planner can run your specific numbers.
Timing matters
The same dollar saves more interest the earlier it goes in. A $5,000 lump sum in year one of a 25-year mortgage saves far more than the same $5,000 in year 20. If you're choosing between prepaying now and prepaying later, now usually wins.
Prepaying just before you break a mortgage can also reduce your penalty, because most penalties are calculated on the outstanding balance. The refinance break-even calculator shows how much.