Break even point of mortgage prepayment penalty vs anniversary payment

Question

I want to calculate the optimal way to apply a $100,000 inheritance to my mortgage and am having difficulty figuring this out. I am in Canada and if I apply all of the money on the mortgage ($170,000 remaining at 3.186%) now I pay a 2.15% penalty on the funds. Alternatively, on the anniversary date every January I can prepay up to $40,000 without a penalty. My local savings rate is 0.8%.

Can you help me figure out if I should pay the $2,150 penalty now and benefit from much lower interest payments immediately or if I should hold onto the $100,000 for now and do $40,000 during the next two January's and $20,000 on the third? I am already doubling my monthly payments so I can't increase those.

Answer 1

I did a rough model and in terms of total $$ paid (interest + penalty - alternative investment income) both options are almost the same with the "paying it all upfront" being perhaps a $300 or so better ($9200 vs $8900)

However, that doesn't factor in inflation or tax considerations. Personally I'd go with the "no-penalty" scenario since you have more flexibility and can adjust along the way if anything else comes up in the meantime.

Answer 2

Your cheapest option is to pay the penalty on $ 60,000 now, and pay the remaining $ 40,000 this coming January. I assume the penalty will be 2.15% of $ 60,000, or $ 1,380.

My logic: The effective cost of the money is 3.186% - 0.8% = 2.386%. Thus, it is worth paying the penalty if and only if you can save at least 11 months of interest by paying the penalty. Eight months of interest differential on the $ 40,000 will be about 1.6%, or $ 640, which is less than the $ 860 penalty you will avoid on the $ 40,000.