Navigating Mortgage Strategies: How Can We Reduce Our Mortgage Interest?
The Current Situation
A young married couple, Gregory and Olivia, live in the Greater Toronto Area (GTA). They bought a home two years ago for $1 million. With a 20% down payment, they borrowed $800,000 to enable the house purchase.
The terms of the mortgage are as follows:
- Rate: 2.60%
- Compounding: Semi-annual
- Amortization period: 25 years (300 months)
- Term: 10 years (120 months)
- First payment date: 2021-07-02
- Payment frequency: Monthly
- Payment: $3,623.69
Greg and Olivia had opted for a 10-year term because mortgage rates were at nearly rock bottom, and they wanted to hang onto a good rate for as long as they could. Even so, a significant portion of their mortgage payments go to interest alone.
Data as of 2023-11-02 Payment
- Remaining amortization period: 22 years 7 months (271 months)
- Remaining mortgage balance: $743,214.71
- Interest payment: $1,605.99
- Principal payment: $2,017.70
Olivia in particular wanted to reduce that interest charge. Despite the large debt, they were managing to save a substantial amount of money. In mid-November 2023, they reviewed their mortgage contract to see what their options were to reduce their interest payments.
Option 1: Annual Prepayments
They read that they could prepay up to 15% of the mortgage principal every year if they wanted to. Fifteen percent of $800,000 is $120,000, which was too much for them to handle. However, they wanted to see what it would be like if they paid a year’s worth of mortgage payments and applied that lump sum to the principal. The monthly payment of $3,623.69 multiplied by 12 works out to $43,484.28. They resolved to make those annual prepayments beginning on the anniversary date of their mortgage in 2024 and ending on the anniversary date in 2030. The results were projected to be as follows as of 2031-06-02, their last payment before a new mortgage term would begin:
- Amortization period: 15 years (180 months)
- Remaining amortization period: 5 years (60 months)
- Remaining mortgage balance: $202,918.57
- Interest payment (2031-06-02): $444.15
- Principal payment (2031-06-02): $3,179.54
Option 2: Monthly Prepayments
Given Greg and Olivia were able to contribute the equivalent of an extra year’s payments annually, they wondered what difference it would make if they doubled up their payments beginning with the December 2, 2023 payment and going all the way to June 2, 2031. This would allow them to get started sooner – next month – and pay to the last payment of the current term 2031-06-02. The results were projected to be as follows:
- Amortization period: 14 years 4 months (172 months)
- Remaining amortization period: 4 years 4 months (52 months)
- Remaining mortgage balance: $176,288.13
- Interest payment (2031-06-02): $394.67
- Principal payment (2031-06-02): $6,852.71 ($3,229.02 if based on a regular payment)
Option 1 and Option 2 Compared
After reviewing the projections, Greg and Olivia noted a few things:
- The remaining amortization period at the beginning of the new term was 8 months shorter for Option 2.
- The remaining mortgage balance was $26,630.04 less for Option 2.
- The interest charge for the final payment of their current term was $49.48 less for Option 2.
- The total value of the extra payments was $25,365.83 more for Option 2. This is equivalent to an extra 7 months of payments.
The higher total value of the extra monthly payments versus the annual payments explains the difference between the two options. What if we equalize the total amount paid?
- Removing the first seven months of monthly payments in Option 2, with the first payment beginning on 2024-07-02, the same date as the first annual payment in Option 1, but still ending on 2031-06-02, results in the following:
- Amortization period: 15 years 1 month (181 months)
- Remaining amortization period: 5 years 1 month (61 months)
- Remaining mortgage balance: $206,878.81
- Interest payment (2031-06-02): $460.45
- Principal payment (2031-06-02): $6,786.93 ($3,163.24 if based on a regular payment)
- Removing the last seven months of monthly payments in Option 2, with the first payment beginning on 2023-12-02, but ending on 2030-11-02 results in the following as of 2031-06-02:
- Amortization period: 15 years (180 months)
- Remaining amortization period: 5 years (60 months)
- Remaining mortgage balance: $201,818.53
- Interest payment (2031-06-02): $441.78
- Principal payment (2031-06-02): $3,181.91
Observations
There is a slight improvement if Greg and Olivia double their monthly payments versus contributing the same amount in lump-sum annual payments. The difference is not enough to reduce the amortization period by even one month, but it does reduce the overall interest charge. This slight advantage can be attributed to the earlier start date of the doubled-up monthly payments versus waiting until the next anniversary date for the first annual payment.
Which Option Should They Choose?
From a purely numbers point of view, it seems clear that doubling up their mortgage payments as soon as possible is preferable to making annual payments on the anniversary date. From a behavioural point of view, too, I would argue that it is easier to make larger monthly payments a regular part of one’s routine than saving up for an annual payment. Once the increased monthly payments are set up, they will automatically come out of your account. Annual payments need to be handled manually. Furthermore, in the intervening months, some other event may occur that will, at that time, assume a larger priority than saving up for that lump sum, quite likely resulting in a lower lump-sum payment in the coming year.
I will mention one other option that a mortgagor should consider. Greg and Olivia are making monthly payments. By making bi-weekly accelerated payments, they halve their monthly payment but make 26 payments in total each year, which can shave years off the total amortization.
Whichever choice Greg and Olivia make, the only real way to reduce the interest paid when the interest rate is locked in is to increase their payments; the sooner they start, the shorter their time in debt and the lower their total interest paid.
Note: I used the Canadian Mortgage Calculator, available to download from Vertex42, for my estimates.
This is the 224th blog post for Russ Writes, first published on 2023-11-20
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
Image source: https://upload.wikimedia.org/wikipedia/commons/9/9b/Toronto_Row_Houses.jpg
