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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.

  • Do you have any other very-low-risk investment opportunities that you can invest similar amounts of money in for 8 - 32 months? For example, how much can you make on government bonds, investment-grade bonds, money market accounts, or bank certificates of deposit? – Jasper Apr 27 '16 at 5:05
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    Do you get any tax deductions for paying the penalty, or for paying the mortgage interest? If so, how much are the tax deductions worth? Could you save on mortgage insurance by reducing your outstanding balance? – Jasper Apr 27 '16 at 5:07
  • @Jasper, I have no mortgage insurance as my down payment was 50%. Mortgage interest can not be written off in Canada. Probably the best rate I can find for the time frame is no more than 1% if I go "guaranteed". – kd7iwp Apr 27 '16 at 13:21
  • May I make an alternative suggestion? Invest the money. When you put that money into your mortgage it reduces your mortgage amount but does not change your monthly outflow. Investing that money keeps the same payment, allows that money to grow, and when the cash on hand meets or exceeds the mortgage balance you can just pay it off. It also keeps that money available should some disaster come up, you cannot get that money back out of the mortgage (at least not without an equity loan, which could be hard to get in the event of illness or job loss). – Freiheit Apr 27 '16 at 18:26
  • @Freiheit, I can see your point, I'm not a fan of the risk on that invested money though, and my goal is to pay it off ASAP so if I put it in the mortgage now, much more of each payment goes toward principal. – kd7iwp May 10 '16 at 22:39
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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.

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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.

  • That's a good idea, I had not considered doing some now and the penalty free in January. – kd7iwp Apr 28 '16 at 16:31

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