A prepayment is a payment a borrower makes that is in excess of scheduled mortgage payment amount specified by the lender.
For extra payment that pays off the entire balance, it is termed as a full prepayment.
Additional payments that do not fully repay the loan balance are called partial prepayments.
Depending on the terms of contract, such action on the part of the borrower might or might not trigger a penalty charge from the lender.
A prepayment clause contained in the contract would either state:
- An absence of penalties
- The amount of penalty charge which is usually a percentage of the principal balance
- A penalty charge as above, but with a specific time period where it will be active
- Whether extra payments go toward reducing the principal
- The maximum limits of prepayment per year
In professional jargon, prepayment clauses that include penalties resulting from refinancing are called soft penalties. While those resulting from both refinancing and the sale of a home are called hard penalties.
Sometimes lenders with a desire to insert prepayment penalties into their mortgage would be willing to lower their interest rates to borrowers in exchange for a prepayment penalty clause.
It can also work the other way around where borrower offer to pay more interest in exchange for no prepayment penalties.
In the past when traditional common law was used, a borrower would have no right to prepay a mortgage unless explicitly stated in the contract via a prepayment clause.
In modern times, a borrower would have full flexibility to prepay if a contract is silent on the subject. So terms regarding this issue are meant to limit the prepayment rights of a borrower.
Should you fully payoff your home loan?
When homeowners are working adults drawing an income with regular increments, it often comes a time when they have enough money to fully prepay the mortgage on the house.
This can present a tough dilemma.
Because it could be the first and only time they have had so much funds sitting in the bank. And it can be emotionally heart-breaking to see it all deposited into home equity.
Here are some considerations to ponder.
Are there any investment opportunities with a rate of return higher than the mortgage rate?
Bare in mind that comparing interest rate on the loan with investment returns can be misleading as mortgage rates are not calculated with simple interest.
Don’t forget to include prepayment penalty fees which you might incurred.
Then use that to compare with the projected investment returns.
Sometimes even interest rates that consumers can earn on time deposits can exceed that of the mortgage.
Your funds can get locked up in the house
If you put all that money into full repayment, you might not see that cash again for a number or years, and even decades.
But that is dangerously assuming that you can get them approved in the first place.
Should your current mortgage be at 5%, getting a new loan against the house in the future at 7% might make you feel a little stupid.
Otherwise, one will have to wait to be eligible for a reverse mortgage to see that money again.
Review the terms of the mortgage contract to find loopholes to exploit
There is nothing wrong with paying hard ball with lenders as long as you are following the rules written in black and white.
You’d expect a lender to fully enforce their terms written in fine print as well.
If you read through the terms of contract carefully regarding prepayment penalties, you might find opportunities to navigate around them.
For example, I have seen for myself how contracts penalize borrowers for full prepayments, but not for partial prepayments.
In those cases, borrowers can just prepay the loan balance leaving it with the minimum required balance.
It might be $5,000, $10,000, 20,000, etc, depending on the terms of contract.
So if a $100,000 outstanding loan with no partial prepayment penalty with a minimum leftover balance of $5,000, a borrower can technically prepay $95,000 without incurring penalty charges, leaving $5,000 to be recast and slowly repaid over the remaining term.
I strongly suggest that you don’t prepay unless you really have absolutely no plans for that money that is sitting in your savings account.
And if there are penalties involved, also remember to calculate the breakeven point to see whether it is financially worthwhile at all.
Partial prepayment vs full repayment
One can start to partially prepay as early as today. All that is needed to be done is to deposit more than the scheduled mortgage payment amount that is due into the loan repayment account, then the people at account servicing will do the rest.
The funds amounting to the obligated payment amount will be used to settle what is due, and the excess will go towards offsetting the principal.
For example, if the monthly mortgage payment is $500 consisting of $400 interest and $100 principal, should a borrower repay $600 instead, then the payment towards principal will become $200.
This extra $100 will effectively payoff two months worth of regular principal repayments.
The automated servicing system should automatically book in the prepayment.
To avoid the frustrating scenario of making excess payments and not having that credited towards the principal as partial prepayment, you might want to consider contacting the lender about your intentions.
This is due to the possibility that they might interpret that extra $100 as part of an early payment towards the monthly mortgage payment for the following month.
Saying that, partial prepayment can have different effects on different types of home loans.
Fixed rate mortgage (FRM)
For FRMs, prepayment will reduce the loan principal balance but will not reduce the monthly installment.
A borrower with the goal of reducing monthly payment to alleviate cash flow problems might find that prepaying has no real impact.
Adjustable rate mortgage (ARM)
On ARMs, the opposite effect is achieved.
Monthly payments would be reduced but the term remains the same.
When prepayments are made on balloons, the monthly payment amount remains the same just like FRM.
The difference is that it would result in a lesser rollover balance at the end of the rollover period.
This would result in a lower monthly payment after the rollover period.
To close off this topic, remember to review investment opportunities available to you.
Because an investment with better returns than the mortgage rate would be more worthwhile.
Other than that, if you have idle funds sitting somewhere, it makes sense to use to prepay the mortgage.