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How Prepaying Your Mortgage Will Help You Become Debt-free Sooner

For many Canadians, their mortgage will be the largest debt they’ll ever take on. Fortunately, taking on a mortgage doesn’t sentence you to a life of debt because there’s a way to pay off your mortgage faster.

By taking advantage of the mortgage prepayment privileges that come with most mortgages, you can become debt-free years, even decades early, and save tens of thousands of dollars in interest charges.

How regular mortgage payments work

When you buy a home and get a mortgage, you must make regular payments on the mortgage until the loan is paid off. Part of that amount will pay the interest that has accrued since the last payment and part of your payment will be applied against the principal loan amount.

After a specified term (called the amortization period), your payments reduce your loan balance to zero. While you may get your mortgage expecting to make the same payment every month for 25 years (subject to interest rate fluctuations, of course), a lot can happen in that time. You may get a raise or inherit money and you might consider using that money to pay down your mortgage quicker.

In this case, you’d want to take advantage of the prepayment options that come with your mortgage. You have two options to prepay your mortgage: A monthly prepayment and a lump-sum payment.

Looking to determine your mortgage payment?

Use the mortgage payment calculator to determine your estimated mortgage payments.

How a monthly prepayment works

If you decide you’d like to become debt-free before the original 25-year amortization period is up, you can prepay your mortgage. If you opt for your mortgage’s monthly prepayment option, you can choose to pay an extra amount of money on top of your monthly mortgage payment up to a maximum percentage specified by your lender.

Depending on the mortgage you choose and your bank’s specific restrictions, your monthly mortgage prepayment could range from 0% to 100% of your monthly mortgage payment.

For example, if you have a $450,000 property and get a mortgage with today’s best mortgage rate of 2.29% amortized over 25 years, and you put 20% down, your monthly mortgage payment would be $1,575 according to a mortgage payment calculator. If your lender allowed a 20% prepayment privilege, you could add up to 20% of your monthly mortgage payment ($1,575 x 20% = $315) on top of your regular monthly payment. Then your total monthly payment would be $1,890 ($1,575 + $315).

If you committed to this monthly prepayment privilege over the life of your 25-year mortgage, you’d pay off your mortgage in 2036 instead of 2041 (five years earlier) and save $24,875 in interest.

How a lump-sum prepayment works

If you’d prefer not to prepay your mortgage every month you have another option: A lump-sum prepayment. With a lump-sum prepayment, your lender will allow you to make one significant prepayment every year. The maximum size of the prepayment will vary from lender to lender but it’s usually within the 0% to 25% range.

Let’s use the same example above and assume that you wanted to make a lump-sum prepayment of 20% of the mortgage’s value every year. That’d be a yearly prepayment of your mortgage amount, which is your home’s value less your down payment amount or $360,000.

That means 20% of your mortgage amount would be $72,000 ($360,000 x 20%). If you paid an extra $72,000 on your mortgage each year, you’d be mortgage-free in 2021 (20 years early) and save $91,536 in mortgage interest.

While $72,000 may sound like an enormous amount of money to put towards your mortgage every year, this could happen if you receive an inheritance, or sell a business or other real estate.

The bottom line

For many Canadians, their mortgage payment is the single largest expense in their monthly budget and it’s easy to imagine how great life would be without a mortgage payment.

Personally, when I buy a home, I plan to make both monthly and yearly lump-sum prepayments on my mortgage because I love the idea of being completely debt-free.

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Flickr: CafeCredit