Understanding Open and Closed Mortgages
Whether you're applying for a new home loan or renewing your current one, you need to decide between an open or closed mortgage.
Closed mortgages are more common, and tend to come with lower interest rates than open mortgages. But open mortgages offer more prepayment flexibility. A closed mortgage costs much more if you have to break your loan agreement.
“Closed vs. open” is an important mortgage choice, so you’ll want to educate yourself about each option before it’s time to make a decision.
What is an open mortgage?
An open mortgage can be repaid in full at any time without triggering a prepayment penalty. You can increase your regular payments and make additional lump-sum payments whenever you want. Doing so can shorten your amortization period and save you some real money.
But this freedom comes at a cost — open mortgage interest rates can be significantly higher than those attached to closed mortgages.
Paying more interest for an open mortgage may not seem to make financial sense, but there are a few situations where it could be beneficial.
For example, if you’re expecting a financial windfall or think you may need to sell your home before the end of the term, an open mortgage could save you from a prepayment penalty. (You may, however, need to pay an administration charge to get released from your open mortgage.)
Pros
- There’s no penalty when increasing your regular payments.
- There’s no charge when you make lump-sum payments.
- Refinancing can be cheaper since you’re not dealing with the penalties related to closed mortgages.
Cons
- You’ll pay higher mortgage rates compared to closed mortgages.
What is a closed mortgage?
With a closed mortgage, once the terms and conditions are set, they are closed — you can’t change or break them without paying a penalty.
The duration of the mortgage term, or how long you’re locked into your mortgage contract, is up to you. It can range from six months to 10 years depending on the options offered by your lender, but most Canadians opt for a five-year term.
Even though your mortgage is closed, your original terms will likely provide some prepayment options. For example, you might be able to prepay up to 20% of the original principal amount of your mortgage once a year.
However, if you need to move or sell your home before the end of the term, you’d likely be forced to break the terms of your mortgage contract. That’s when you’d be hit with fees and prepayment penalties.
Closed mortgage prepayment penalties
If you break a closed fixed-rate mortgage, you’ll likely be charged the interest remaining for the term, which is based on a calculation called the interest rate differential (IRD). The earlier into a term you break a closed fixed-rate mortgage, the higher your penalty will be.
If you break a closed, variable-rate mortgage, your pre-payment penalty will typically be the equivalent of three months’ interest.
The penalties for breaking a closed mortgage can be steep since they’re a way for lenders to recuperate lost income and continue providing mortgages with low rates. Those low interest rates are why most homeowners go with closed mortgages, but the prepayment penalties make them a bit of a gamble.
Pros
- You’ll pay lower mortgage rates compared to open mortgages.
- Lenders generally offer prepayment and lump-sum payment options.
Cons
- There’s a limit to how much you can prepay, if you can at all.
- You may pay huge penalties if you need to break your mortgage.
How to choose between open and closed mortgages
When deciding between open and closed mortgages, ask yourself the following questions:
Am I expecting an inheritance or large sum of cash in the near future that I could use to pay off my mortgage ahead of schedule?
Will I likely move or sell the home before my mortgage term ends?
Might my household income increase to the point where I could make bigger monthly mortgage payments?
If you answered yes to any of these questions, an open mortgage could help you avoid high fees when breaking your mortgage.
You could also consider a short-term convertible mortgage instead. Convertible mortgages typically last for six months and offer interest rates somewhere between those of closed and open mortgages. If you take out a convertible mortgage, you can extend it at the new rate as needed. Then once your situation is more settled — or interest rates fall — you can lock into a longer-term option.
Most homeowners expect to stay put for the length of their mortgage term, so they’re more than happy to take the lower rates that come with a closed mortgage. Regardless of what mortgage product you go with, you need to make sure you understand the terms and conditions so there are no surprises if your circumstances — and mortgage needs — change.
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Clay Jarvis
Clay Jarvis
Clay Jarvis