Prepaying your mortgage or loan as a newcomer in Canada

As you settle down in Canada, you may need a loan or mortgage to achieve some of your financial goals, such as buying a car or house or pursuing higher education. When you get a loan or mortgage, you tend to base your repayment schedule and terms on your affordability at the time. But what if your income increases a few years later and you can afford larger repayments? 

As a newcomer, it can take time to find a job in Canada that aligns with your experience, but when you do, your income may increase significantly, and you may want to use your extra earnings to eliminate your debt sooner. In this article, we evaluate the pros and cons of prepaying your mortgage or loan to help you make financial decisions that work best for you.

In this article:

• What does prepaying a mortgage or loan mean?
• Advantages of prepaying your mortgage or loan
• Disadvantages of prepaying your loan or mortgage
• What is a prepayment penalty on a loan or mortgage?
• How is the prepayment penalty calculated on loans and mortgages?
• Should I prepay my mortgage or loan?
• How to avoid prepayment penalty on your loan or mortgage

What does prepaying a mortgage or loan mean?

When you get a mortgage or loan in Canada, it is for a specified period or term. For instance, car loans are usually issued for a one to eight-year period, with five-year terms being the most common in Canada. If you apply for a student loan in Canada, your loan term may be between three and 20 years, depending on the loan amount and lender. (Note: Most Canadian banks don’t offer student loans to international students, so unless you’re a Canadian permanent resident or citizen, you may need to apply for a loan from a financial institution in your home country.) 

With loans, you need to repay the entire amount within the specified term, but mortgages work a little differently. When you purchase a house, the expected time you’ll take to fully pay off your mortgage, also known as the amortization period, is usually around 20 or 30 years. However, the mortgage term is the duration of your mortgage contract, which typically ranges between one and ten years, with five-year terms being the most common. You need to renew your mortgage contract at the end of each term, with the same or different mortgage provider, until your debt is fully paid off.

As a newcomer, your financial situation may improve over time, and you may be able to afford to make larger payments towards your loan or mortgage to pay it off sooner and save money on interest. Prepaying a mortgage or loan means repaying part or all of the loan amount before your payment term ends. 

Since lenders lose out on interest earnings when people prepay their debt, many loan and mortgage providers include prepayment terms in their agreement. Often, these clauses include how much and how frequently you can prepay, as well as penalties the financial institution charges for prepayment.

Advantages of prepaying your mortgage or loan

As a newcomer, prepaying your mortgage or loan can have several advantages. These include:

• Prepayment can help you pay off debt faster. For instance, let’s say you have a $30,000 car loan for a five-year term at a four per cent interest rate, and your monthly loan payment is around $552.50. If you were to pay an extra $200 towards your loan every month, you could potentially pay off your loan in 3.6 years (or 16 months sooner).
• Prepaying your mortgage or loan can reduce the total interest you pay. By prepaying all or part of your debt, you can save on the interest you would otherwise pay on the differential amount for several more years. For instance, if you prepay $10,000 on your mortgage in the second year of your 25-year amortization period, you can reduce the interest owed on $10,000 for 23 years from your overall cost of borrowing (principal plus total interest).
• Prepayment can help you build more equity in your asset. When you get a mortgage to purchase a house, your equity in the house is equal to the market value of the asset minus your outstanding mortgage balance. As you pay down your mortgage, your equity in the asset increases.
• For mortgages, prepayment can help you lower your monthly payments. When your contract is up for renewal at the end of your mortgage term, you may have the option of renegotiating your mortgage to lower your monthly payments if you’ve made a sizable prepayment.

Disadvantages of prepaying your loan or mortgage

Despite its benefits, prepaying your loan or mortgage may not necessarily be the right approach for you. Here are some potential disadvantages of prepayment that you may want to take into account:

• Prepayment penalties may apply. Before making any prepayments towards your mortgage or loan, carefully read your contract to see if the financial institution charges any prepayment penalty. Calculate the penalty amount you need to pay and compare it against the reduction in your overall cost of borrowing to see if you’ll save any money in the long run.
• Prepaying your mortgage or loan can lower your cash flow. If you plan to use your savings to prepay your debt, make a budget to ensure you have enough money set aside for emergencies or other expenses.
• If the interest rate on your debt is low, investing that money elsewhere might make more financial sense. It’s a good idea to estimate the opportunity cost of prepaying your loan or mortgage. For instance, if you pay an interest rate of two per cent on your loan but your Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) investments grow at an average rate of six per cent per year, you may want to consider investing the amount instead of using it to prepay your debt.

What is a prepayment penalty on a loan or mortgage?

Many loan and mortgage companies charge a prepayment penalty to recover some of the interest earnings they lose when you pay off all or part of your loan or mortgage early.

Let’s say you purchase a house and, after paying the down payment, get a 25-year mortgage for $600,000 at an interest rate of three per cent with a five-year term and monthly payment schedule. Over the 25-year amortization period, you’ll pay close to $251,840 in interest. Now, if you prepay a one-time lump sum of $30,000 in the third year of your amortization period, you can reduce your mortgage repayment duration by nearly 1.6 years and save $26,280 in total interest over your mortgage duration.

In this scenario, the mortgage provider stands to lose $26,280 of their expected revenue over the lifetime of your mortgage. To minimize this loss, they may include a prepayment penalty clause in their contract that discourages prepayments or partly reimburses them for lost earnings.

Some mortgage and loan providers include prepayment privilege clauses in their agreement, which allow you to prepay up to a certain amount in a year or term without penalty. For instance, some lenders may allow you to prepay up to 10 or 20 per cent of your remaining principal amount each year without any penalty or increase your bi-weekly/monthly payments by 10 or 20 per cent. However, if you prepay more than the amount permitted, you’ll have to pay a prepayment penalty.

Loans with shorter terms, such as car loans, are less likely to carry heavy penalties, while longer-term debt, such as mortgages, have higher penalties since the lender loses more interest when you prepay. You may also incur a prepayment penalty if you break your loan or mortgage contract and switch to another lender.

How is the prepayment penalty calculated on loans and mortgages?

Typically, the prepayment penalty that applies when you pay off all or part of your debt early will depend on the following factors:

• The amount you prepay
• Interest rate
• The remaining duration of your term
• The calculation method your lender uses

Financial institutions use different methods to calculate prepayment penalties. In Canada, the prepayment penalty is usually calculated as the higher of:

• Three months’ interest on the prepaid amount, or
• The interest rate differential (IRD) or the difference between the interest rate you’re paying and the rate the lender can get by re-lending the money, multiplied by the prepayment amount and the number of months remaining in your term.

Your mortgage or loan contract will mention the lender’s calculation method, so be sure to read the terms carefully before you make any prepayments.

Tip: For mortgages, the prepayment penalty is calculated on the mortgage term, not the amortization period. So the penalty may be lower if you prepay your debt closer to the end of your term.

Should I prepay my mortgage or loan?

There is no one-size-fits-all answer to whether or not you should prepay your mortgage or loan. The right approach for you will depend on whether you save money in the long run by prepaying, your cash flow situation, and other financial goals. 

To determine whether prepayment will lead to significant savings, you should take into account the amount you plan to prepay, your debt balance, the remaining duration of your term, the prepayment privilege and penalties clauses in your contract, as well as the interest rate you’re paying versus the current market interest rate.

When does prepaying your mortgage or loan make sense?

It may be beneficial to prepay part or all of your mortgage or loan balance if any of the following apply to you:

• You have more cash flow, or your income has increased. As a newcomer, your income may increase as you progress in your career and become more financially established in Canada. You may want to use your extra income, bonuses, or self-employment earnings from a side-hustle to prepay your mortgage or loan. If you have proceeds from the sale of an asset or savings in your home country or have come into an inheritance, you can use those funds to prepay your debt. You may also have more money to spare on a monthly basis if your child has entered Kindergarten and you no longer have to pay for daycare.
• You are paying a high interest rate or anticipate that your interest rate will increase soon. If the interest rate you pay on your debt is higher than the average growth rate of your investments or savings, there may be merit in using spare funds to prepay your mortgage. 
• Your mortgage or loan contract offers prepayment privileges. You may save money by prepaying if you make a partial prepayment that does not incur a prepayment penalty or if prepaying will significantly reduce your total cost of borrowing, even with the prepayment penalty.
• You don’t need the extra money for your goals or expenses. Keep your expenses and short- and medium-term goals in mind while deciding whether or not to prepay debt. Make sure you won’t feel a financial crunch by making extra payments toward your loan or mortgage. If you have other higher-interest debt, such as credit card debt, be sure to repay those before putting additional money towards your mortgage or loan.
• You are trying to become debt-free sooner. If your objective is to fully pay off your mortgage or loan sooner, prepayments can help reduce your repayment duration. For instance, you may want to pay off your mortgage before retirement or prepay your car loan before purchasing a second vehicle.

If you’re unsure whether prepaying your debt is the right financial move for you, you can speak to a newcomer financial advisor for personalized guidance based on your unique situation.

How to avoid a prepayment penalty on your loan or mortgage

There are several ways to increase your payments towards your loan or mortgage without having to pay a prepayment penalty. Some options include:

• Using your prepayment privilege: If your loan or mortgage contract includes prepayment privilege, you can prepay up to a certain amount without penalty each year. 
• Make a large prepayment towards the end of your term: The shorter the remaining duration of your repayment term, the smaller your prepayment penalty will be. However, many mortgage providers restrict prepayments in the last year of your term, so check your agreement carefully and plan your prepayment as late as your contract permits.
• Opt for accelerated payments: When you sign a loan or mortgage contract, you’ll choose a payment frequency. Besides weekly or monthly payments, you may also have the option of making accelerated bi-weekly payments, which allow you to pay 26 installments instead of 24 per year or the equivalent of 13 monthly payments in a year, to reduce your amortization period by anywhere between 1.5 to three years. 
• Transfer or port your mortgage or loan instead of breaking it: If you plan to sell your house or car to buy a new one, ask the lender if you can port your existing mortgage or loan. This will save you from breaking your mortgage and having to pay a prepayment penalty. In some cases, lenders also allow you to transfer your loan or mortgage to the buyer instead of ending your contract early.

As you start to fulfil your financial goals as a newcomer in Canada, you may rely on loans and mortgages from time to time. Familiarizing yourself with commonly-used loan and mortgage terms, such as debt prepayment and the penalties that may come with it, can help you make better financial choices in the long run.

Arrive is powered by RBC Ventures Inc, a subsidiary of Royal Bank of Canada. In collaboration with RBC, Arrive is dedicated to helping newcomers achieve their life, career, and financial goals in Canada. An important part of establishing your financial life in Canada is finding the right partner to invest in your financial success. RBC is the largest bank in Canada* and here to be your partner in all of your financial needs. RBC supports Arrive, and with a 150-year commitment to newcomer success in Canada, RBC goes the extra mile in support and funding to ensure that the Arrive newcomer platform is free to all. 

* Based on market capitalization