A Great Way to Reduce Interest Not Paid to the Bank

I recently had a conversation with a Customer Banking Representative of a major Chartered Bank.  We were talking about the 20/20 pre-payment features included in many mortgage products.  I asked her how many people actually took full advantage of this option.  She smiled coyly.  I asked her, why the smile?  She told me that she was recently at a convention for her employer and they presented statistics that stated that only six (6) mortgage borrowers in the Ontario market took advantage of the full 20/20 feature for 2013.  Six!  She also stated that they were high income Bay Street earners.  Wow!

While many of us will never be in a position to use the feature to the fullest, I started thinking about the power of using this feature within the constraints of a personal budget.  This immediately brought to mind a recent experience I had consulting with some mortgage borrowers.

Imagine the following:

• Husband is a contractor
• Wife is employed in the medial administration field
• High amount of equity in home (approximately 50%)
• Mortgage requirement $280,000 on a refinance
• Past multiple refinances and equity take-outs over the years due to past credit challenges and seasonal wage fluctuations
• Credit scores have been brought back up over time with a lot of hard work
• A set monthly payment is preferred as it would allow them to budget accordingly
• Monthly budget comfort level is $2,000 for mortgage payment (principle and interest)

Options to Consider:

• Use a longer amortization period and the benefits of a 20/20 prepayment privilege to pay off the mortgage in a shorter period of time AND significantly reduce the total amount of interest paid
• The approach will have the $2,000 per month used as the baseline while increasing the monthly payment up to the $2,000 budget or to increase the monthly payment by 20%
• In the case where the P & I plus 20% increase are lower than the $2,000 budget, the difference is put into a savings account and accumulated each month and paid directly to the principle on each anniversary date across the amortization of the loan
• The primary benefit to this approach for these clients is that they can revert to the registered monthly obligation if required (due to seasonal wage fluctuations)

Let’s examine the numbers:

Term/Amortization Years	5-15	5-20	5-25	5-30
P & I Payment	$1,923.17	$1,541.99	$1,316.49	$1,168.77
Months/Years	180/15	240/20	300/25	360/30
Total Interest Paid Across Amortization	$66,168.92	$90,075.75	$114,943.58	$140,756.08
Extra Payment to Monthly Budget	4%	20%	20%	20%
New Months/Years	172/14.34	189/15.75	233/19.4	274/22.8
Extra Payments per Year to Budget	$0	$2,000	$5,000	$7,000
New Months/Years	172/14.34	171/14.25	174/14.5	177/14.75
Total Interest Paid Across Amortization	$62,824.08	$62,595.27	$64,150.41	$65,084.50
Difference in interest paid on each amortization if no 20/20 used	$3,344.84	$27,480.48	$50,793.17	$75,671.58

While many borrowers may not qualify for a 30-year amortization, this chart stresses a few important factors:

• If your situation warrants, consider not matching your monthly budget to your minimum principle and interest payment and use your prepayment privileges to pay directly to your principle by increasing the amortization period
• Use your prepayment privileges to reduce the amortization period and significantly reduce the amount of interest NOT PAID to the bank
• This strategy might be effective for the borrower if seasonal wage fluctuations are a concern

Please note there are many factors used to qualify each borrower and this example is used to illustrate the effect of using prepayment privileges across time.  Also, this example assumes a constant interest rate across the amortization (which may or may not happen – let me know if you have a crystal ball).

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