|This information applies to British Columbia, Canada. Last reviewed for legal accuracy by Alison Ward in August 2018.|
Prepayment rights enable a borrower to pay off or pay down a debt earlier than when periodic payments are due.
- Client wants to pay off a mortgage and wants to know if they can do this and how much has to be paid.
- Client wants to pay off a consumer loan or a credit card account and wants to know if they can do this and how much has to be paid.
Summary of the law
In common law, parties can set out a variety of terms in a credit agreement. One important term is whether the borrower is allowed to pay off or pay down the obligation earlier than when the periodic payments (for example, the monthly payments) are due. This is called the right of prepayment.
The advantage to the borrower in prepaying is that the amount of interest paid to the lender is smaller. This may be particularly important for two reasons:
- When interest rates are relatively high, the borrower usually wants to pay off an obligation as fast as possible.
- If interest rates drop during the term of the credit agreement, the borrower may be able to borrow elsewhere at a lower interest rate and pay off the old obligation. Or the borrower may seek to renegotiate a lower interest rate with the existing lender.
In general, the common-law principle says there is no right of prepayment of a credit agreement unless there is a specific term in the agreement saying the borrower can do this. The borrower is obliged to pay principal and interest each month until the end of the agreement. While the parties could renegotiate the agreement to allow for prepayment, the borrower could not force the creditor to accept other than what is called for in the credit agreement: full principal and all the interest payable over the full term of the agreement.
Statutory provisions now govern non-mortgage prepayment rights, making common-law principles irrelevant to non-mortgage credit agreements. Common-law principles still apply to mortgages, however.
Non-mortgage credit agreements
Prepayment rights for consumer loans and consumer credit card accounts are governed by section 74 of the Business Practices and Consumer Protection Act and Regulations. (In addition, certain aspects of prepayment for bank loans are covered in the federal Bank Act and Regulations.)
Prepayment rights are rights for individual consumers only, not incorporated companies. The rights do not apply to individuals who enter into credit arrangements for business purposes. They do apply where there is a security agreement in addition to the borrower’s promise to pay.
There are two important aspects to section 74 of the Business Practices and Consumer Protection Act. The first is that consumers are given a statutory right to prepay any credit agreement to which the Act applies, except mortgages on land. Consumers can prepay some or all of a credit agreement. Under section 3 of the Act, this statutory right to prepay cannot be waived by a borrower — it is a right, no matter what the credit contract says about prepayment. The creditor cannot charge for prepayment, whether full or partial.
The second important aspect to section 74 is that it regulates how much of the non-interest finance charges the creditor can require as part of accepting a prepayment. For full prepayment, the creditor must refund the prescribed portion of any non-interest finance charges paid by the borrower or added to the outstanding balance.
For partial repayments, the borrower is not entitled to a refund or credit of any non-interest finance charges.
Most consumers have some idea of the terms “open” and “closed” mortgages. These descriptions refer to the common-law rights of prepayment, which the parties agree to in the mortgage agreement. Open mortgages allow prepayment; closed mortgages do not allow prepayment. In addition, consumers can negotiate some mortgages that allow limited rights of prepayment (for example, the borrower can prepay a percentage of the outstanding principal once each year, or elect to double the amount of the periodic payments).
The important advantage of an open mortgage to the borrower is the flexibility to prepay or renegotiate the mortgage if interest rates drop. For this reason, lenders usually charge a slightly higher rate for open mortgages than for closed mortgages over a comparable term.
Prepayment rights for mortgages on land are governed by section 10 of the Interest Act (Canada). Under that section, consumers have more limited rights of prepayment than for non-mortgage agreements governed by the Business Practices and Consumer Protection Act. Basically, there is no statutory right of prepayment where the term of the mortgage is five years or less. For example, a borrower does not have a statutory right to prepay a closed mortgage with a three-year term. If the borrower wants to pay out the mortgage, they must negotiate with the lender. In general, lenders are unwilling to allow a mortgage prepayment without at least some additional interest being paid if current interest rates are lower than the rate agreed to in the mortgage. The lender may well insist that all the interest over the term of the mortgage be paid. This makes prepayment expensive and uneconomic, particularly in the early part of the term of the mortgage.
Where the term of the mortgage is for more than five years, the borrower effectively does have a right of prepayment. Section 10 of the Interest Act says that if a creditor refuses a prepayment offer, the borrower is not obliged to pay any further interest. There are two important qualifications to this prepayment right:
- the prepayment can only be made after the first five years of the mortgage, and
- the borrower has to pay three months’ worth of interest in addition to the principal amount.
Gather and confirm all information about the loan and credit agreement or contract.
Solving the problem
Your main concern when dealing with prepayment rights is probably ensuring that the amount to be paid out is correct. If there is any concern about the calculation of the balance due, it may be wise to ask a professional, such as an accountant or an actuary (or perhaps a credit union manager), for a second opinion.
Related topics and materials
See other sections on mortgages and secured loans:
See related topics:
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