Paying off your mortgage early can cost you

Paying off your mortgage early seems like great financial planning since you’re freeing up money that can be put towards savings.

But discharging a mortgage early can mean a prepayment penalty because the bank loses money. If you had a two-year term and paid the mortgage in full after 16 months, the bank is out eight months of interest. They charge the difference so they don't lose out. The closer you are to the end of the mortgage, the smaller the penalty but it's money out of your pocket.

For those lucky enough to be near the end of their mortgages and ready to hold a mortgage burning party, they need to keep an eye on the mortgage statement that shows the principal/interest mix if they want to avoid penalties. This is particularly true for those with a variable rate.

People with variable mortgages pay fixed amounts, but the amount going towards principal and interest fluctuates depending on prime. If the prime rate decreases, more of the payment goes to the principal and less to interest. While decreasing principal is great, you’ll be hit with a penalty if the mortgage ends before the term does because the bank loses interest payments.

There's not as much worry for those paying fixed rates; just skip double-up-payments unless the bank agrees that you can retire the mortgage early.

If you’re close to the end of your mortgage, but don’t have enough cash on hand to retire it outright at the end of the mortgage term, you’ll need to renew for a short period. Here are a several options that will not incur prepayment penalties:

-  Take out a short-term variable-rate-mortgage and keep monthly payments the same. Pay any leftover amount at the end to retire the mortgage. You’ll need modest extra savings for this plan but make sure that if prime drops, you aren't in jeopardy of paying it off early.

- Take out a short-term fixed-rate-mortgage and increase monthly payments so that the principal will be paid in full at the conclusion of the term.

- Increase the mortgage term and decrease payments. This will add to the length of time that you pay off your mortgage, but will help if finances are tight. Again, for those paying a variable rate, religiously check your balance in the last three months to ensure you don’t inadvertently pay the mortgage in full ahead of time.

Contact Peggy Mackenzie at pmackenzie@thestar.ca or follow her on Twitter:@PeggyMackenzie

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