Know your options before you get a mortgage: Mortgage repayment plans and options.
In today’s market, there are many features that lenders offer borrowers to suit their financing needs. Increasing competition among lenders resulted in lenders adapting their mortgages to the needs of borrowers.
It is important to know your options before you sign a mortgage contract. Depending on the options, you can get additional flexibility in terms of repaying, exiting, and otherwise changing the terms of your mortgage.
The features and options of a mortgage can be broken down into the following categories:
Cash Back Options
Let's deep dive into each of the above to see how they can benefit us by adding flexibility.
Mortgage Prepayment Options
Lenders offer different options to pay the mortgage off sooner than was agreed to in the original mortgage contract. With mortgage prepayment options, the borrower has options to enhance the repayment plan by determining the type of prepayment features.
a) Fully Open Mortgage Prepayment Option
A fully open mortgage allows the borrower to repay the mortgage, in whole or in part, at any time without penalty or notice. This option is especially beneficial to borrowers who expect to receive large cash amounts in the near future, such as from property sales or inheritance. The fully open mortgage prepayment plan can also benefit a borrower in times of declining interest rates. The borrower can switch to another lender and refinance at a lower rate with no penalty.
Fully Open Prepayment Option Benefits
Fully Open Prepayment Option Risks
❑ Flexibility The mortgage can be repaid at any time, providing the borrower with the flexibility to pay the mortgage off in full at any moment. The cash to repay may come from the borrower's own proceeds or refinance the mortgage with another lender. ❑ No penalties A fully open mortgage has no prepayment penalties, meaning that the borrower can prepay the mortgage without being charged the 3-month interest penalty or the interest rate differential.
❑ Higher Rate Most fully open mortgages are at a higher interest rate due to the higher risk to the lender. This is primarily due to the fact that the lender has no guarantee of how long the borrower will stay with the lender. This means that the lender has no certainty about the overall rate of return on the mortgage.
b) Partially Open Mortgage Prepayment Option
A partially open mortgage allows the borrower to repay the mortgage in whole with a penalty of either 3 months’ worth of interest or the interest rate differential (the difference between the mortgage’s rate and the lender’s current mortgage rate).
Partially Open Mortgage Prepayment Option Benefits
Partially Open Mortgage Prepayment Option Risks
❑ Flexibility The mortgage can be repaid at any time, providing the borrower with the flexibility to pay the mortgage off from their own proceeds or refinance the mortgage with another lender.
❑ Higher Rate Although this option doesn’t carry the same rate premium as the Fully Open feature, it can come with a higher rate than found in a closed mortgage. ❑ Penalties Although it offers the flexibility to prepay the mortgage at any time, the penalty to fully prepay the mortgage may outweigh the benefits of refinancing with a different lender.
c) Closed Mortgage Prepayment Option
The main characteristic of this feature is that it does not allow for full prepayment at any time during the term of the mortgage except by the sale of the property. It also has to be an arm’s length sale, meaning that a borrower cannot sell the property to a family member simply to repay the mortgage.
Although this type of mortgage prepayment is less common, several lenders do offer it. It is important to read the contract to ensure you fully understand the terms.
Closed Mortgage Prepayment Option Benefits
Closed Mortgage Prepayment Option Risks
❑ Rate Since this type of prepayment feature provides the lender with significant security regarding their mortgage portfolio, they are often inclined to provide the lowest rates on their closed mortgages. If the borrower is fairly certain that they won’t need to refinance their mortgage or prepay it in full during the term, then this type of feature can be financially beneficial due to the lower rate.
❑ Lack of Flexibility As the borrower is “locked-in” on this mortgage, they have no flexibility to prepay the entire mortgage amount or refinance with another lender. This can limit his or her options if rates decrease or if he or she wishes to increase his or her mortgage amount.
Mortgage Repayment Options
a) Periodic Payment Increase
This option allows the borrower to increase monthly payment, in many cases up to 100% of the original payment amount, during the term of the mortgage. This can be an extremely important feature when it comes to paying a mortgage off more quickly and saving money in the process. On another positive note, if the lender realizes the increased payment is too much for the budget, most lenders will allow the borrower to lower the monthly payment to an amount no less than the original payment amount.
Periodic Payment Increase Benefits
Periodic Payment Increase Risks
❑ Savings As is illustrated by the above chart, the effects of an increased payment will save substantial sums over time.
❑ Cash Flow Since the payment amount is increased, there is a decrease in the borrower’s cash flow. This must be examined before increasing the payment amount to ensure that the borrower will not be negatively impacted.
b) Accelerated Mortgage Payment
An accelerated mortgage payment option is simply an option that provides for an increased periodic mortgage payment using a certain approach that is commonly used by lenders. It has to do with the number of payments in a year. Let's look at an example to explain:
Let's say you have a mortgage and are paying $1264 every month, which amounts to $15,168 per year. If you use an accelerated bi-weekly payment plan, you would be paying $1264 every 4 weeks (or $632 every 2 weeks). Thus, you would pay $15,168 in just 46 weeks of the year and then an additional $1264 for the final 4 weeks of the year. This means you are technically paying more per year and repaying your mortgage faster, ultimately reducing the amortization period and interest. With this option, you are not locked into having your payments made every 2 weeks. You can still choose to pay monthly or 2 times or month, but your amounts would be adjusted to account for the higher annual payment.
Accelerated Mortgage Payment Benefits
Accelerated Mortgage Payment Risks
❑ Savings As discussed, the effects of an accelerated payment are clear: it can save thousands of dollars in interest on the mortgage.
❑ Cash Flow The effect of accelerating a mortgage is increasing the mortgage payment. Since the payment amount is increased, there is a decrease in the borrower’s cash flow. This must be examined to make sure the extra payment is not negatively impacting the borrower's budget.
c) Lump Sum Payment
This option allows the borrower to make a lump sum payment which is applied directly to the principal amount of the mortgage. This, in addition to the payment increase discussed previously, can significantly decrease the amortization period of the mortgage and increase the savings over time by decreasing the amount of interest payable. As is the case with periodic payment increases, the effect of making a lump sum payment will be most significant the earlier it is made. For example, making lump-sum payments during the last few years of the mortgage amortization period will have very little impact on savings vs. a lump-sum payment in the first few years of the mortgage.
Mortgage Cash Back Option
In this type of option, the borrower receives an amount of cash on closing (the time that the mortgage funds), which represents a percentage of the total loan amount. The amount of the Cash Back option can range from 1% to 7%, depending on the lender and the product.
Mortgage Cash Back Option Benefits
Mortgage Cash Back Option Risks
❑ Cash on Closing Since many homebuyers, especially first-time home buyers, invest all of their money as a down payment, it may be beneficial to receive funds on closing that could be used to purchase appliances, finance renovations, replenish bank accounts, etc.
❑ Higher Rate Most Cash Back Options come with a higher rate of interest on the mortgage. This is designed to offset the cost of advancing additional monies that do not have to be repaid by the borrower. ❑ Repayment of the Cash Back If the borrower decides to refinance their mortgage during the term, they will be required to repay a portion of the amount that was received under this option.
Mortgage Combined or Bundled Option
The combined and bundles options are the different names for the same option. Offered by some lenders, this option provides the borrower with 2 products at the same time: the mortgage itself and a line of credit. If, for example, a borrower were to take out a $200,000 mortgage, this amount would be split into a standard mortgage and a line of credit. The mortgage amount would start at $200,000, and the line of credit balance would start at $0. Then every payment against the mortgage loan, as the principal on the mortgage would be reduced, and the line of credit room would increase. Over time, as the mortgage amount owed decreases, the available line of credit increases. The borrower can then use this available line of credit for other needs, if needed and when needed.
Mortgage Combined or Bundled Option Benefits
Mortgage Combined or Bundled Option Risk
❑ Flexibility This type of option allows the borrower to have access to the equity of his or her property at any time by way of the line of credit without having to reapply to borrow additional funds.
❑ Registered Debt The full amount of the $200,000 Bundle (in our case) is always registered against the title of the property. Whereas in a standard mortgage, the amount registered against the property decreases as the debt decreases, the amount of the Bundle remains constant at the total amount originally approved.
Mortgage Portability Option
The Portability Option allows the current homeowner to effectively take his or her current mortgage to his or her new home. Under a typical scenario, the borrower would be selling the current home and purchasing a new one.
Mortgage Portability Option Benefits
Mortgage Portability Option Risks
❑ Rate Protection If rates are currently higher than the borrower’s contracted interest rate on the mortgage, he or she can benefit by keeping the lower rate and porting it to the new home.
❑ Limited Application This feature can be fantastic when current market interest rates are higher than the borrower’s contracted rate, but in an era with consistently low rates, the application of this option is limited.
Mortgage Assumability Option
An Assumable Option allows a purchaser to assume or take over the current homeowner’s debt on the property being purchased. For the current borrower to be released from their covenant with the lender, the purchaser must be approved by the lender and complete an Assumption Agreement.
Mortgage Assumability Option Benefits
Mortgage Assumability Option Risks
❑ Rate Protection If market interest rates are currently higher than the rate of the existing, assumable mortgage, it may be beneficial for the purchaser to assume the current mortgage.
❑ Limited Application This feature can also be very beneficial when current market interest rates are higher than the borrower’s contracted rate, but in an era with consistently low rates, the application of this option is limited.
In summary, there are a number of mortgage features and options that the borrower should be aware of when signing a contract with the lender. Knowing the benefits and risks of the different options and asking about the availability of these options can help the borrower in the future. The benefits that the borrower may realize through the different options are flexibility of repaying the mortgage, exiting the mortgage, porting the mortgage to a new property, and the ability to access home equity through the line of credit.