Choosing the right mortgage is just as important as choosing the right house.
Chances are if you’re looking to buy a new home, then you’ve already done a bunch of research on the different mortgage products out there, and maybe you’ve even decided if you want a fixed or variable mortgage. At the same time, you’ll have to decide whether you want an open or closed mortgage.
The major difference between the two is whether the mortgage allows you to pay it off or renegotiate it before the term is over. Today we’ll cover all you need to know about open and closed mortgages, including details about how they work, the pros and cons of each, and when you might want one instead of the other.
Contents
What is a closed mortgage?
A closed mortgage is one that has a set term, a set payment frequency, a set payment amount, and cannot be paid off or renegotiated before the term is over.
The only way you can pay more than the regular amount, pay off the mortgage in full, or renegotiate before the term is over is by paying a penalty. In other words, you have to abide by the terms and conditions of the mortgage unless you want to incur a penalty.
That being said, most closed mortgages allow specific limited prepayment privileges. For instance, you may be able to increase your monthly payments by a certain percentage, or double your monthly payments. Others might let you prepay a lump sum once a year, such as on the anniversary of the mortgage date.
Prepayment privileges with a closed mortgage will vary from lender to lender, but you’ll generally be able to put down an additional 15% on the mortgage each year, either through increased monthly payments or lump sum payments.
What is an open mortgage?
An open mortgage is the opposite of a closed mortgage in the sense that you can pay it off, pay lump sums, or refinance the mortgage at any time, penalty-free. Unlike a closed mortgage, there are no restrictions on when you can pay, how much you can pay, or when you can refinance.
Like a closed mortgage, you still have to negotiate an open mortgage for a specific term, but you can renegotiate when you want to accommodate your wants, needs, and financial goals.
One of the best things about an open mortgage is that it gives you the flexibility to pay off your home loan faster. For example, if you come into money through an inheritance, you can put down a lump sum toward the principal. Similarly, if you get a raise or a bonus at work, you can increase your regular payments and shave years off your mortgage and thousands off the interest you’ll pay.
What are the pros of a closed mortgage?
Lower interest rates
The major benefit of a closed mortgage is a lower interest rate compared to an open mortgage. Lenders offer a lower rate on closed mortgages because they know they’ll still make more money over the life of the mortgage, and because they can make money from prepayment penalties.
Potential for a lower cost of borrowing
The interest rate on closed mortgages is lower than with open ones, so you could potentially pay your mortgage off faster and spend less money on interest over the life of the mortgage.
Loan term flexibility
You have more choice when it comes to loan terms. The term length for a closed mortgage can range anywhere from 6 months to 10 years, so you have options to suit your plans and goals.
Some prepayment privileges
As mentioned, most lenders do allow for some prepayment options with closed mortgages. If you’re looking for the most flexibility, shop around and see what terms different lenders are willing to offer.
What are the cons of a closed mortgage?
More restrictions
Closed mortgages bind you to the terms of the contract, so you can’t easily break the mortgage by trying to renegotiate or refinance the mortgage before the term is up. Further, while most closed mortgages do allow some prepayments, there are still restrictions on how much you can pay and when.
Penalties
If you do want to renegotiate or pay down the mortgage beyond what the terms of the contract allow, then you’ll have to pay what could end up being a hefty penalty.
What are prepayment penalties?
Prepayment penalties are the additional fees you’ll have to pay with a closed mortgage if you:
- Pay the mortgage off early
- Pay more toward the mortgage in a year than the conditions allow
- Refinance before the term ends
What do prepayment penalties cost?
As with most aspects of a mortgage, the prepayment penalties will depend on the lender and the terms and conditions of your mortgage.
For the most part, prepayment penalties will either cost you three months’ interest or the interest rate differential (IRD). As a penalty, your lender will charge you the higher amount.
Interest rate differential
The interest rate differential is the difference between what you’re currently paying in interest over the mortgage term versus what the bank can make now on a new mortgage. For example, if your mortgage has an interest rate of 5% but the going rate for a mortgage now is only 3.5%, then you’ll be responsible for paying that 1.5% difference.
Calculating prepayment penalties
To calculate a prepayment penalty, the lender will look at both three months’ interest and the IRD and choose the higher number. With the interest rate of 5%, say you were paying $550 in interest each month, so three months’ interest would result in a prepayment penalty of $1,650. However, if the IRD works out to be $2,500, for instance, then you’ll have to pay $2,500.
What are the pros of an open mortgage?
No restrictions on repayments
One of the best things about an open mortgage is you can pay off as much as you want, whenever you want, and you’ll never have to pay a penalty.
Won some money on the lottery? Put down a lump sum payment on your mortgage and have it go directly to the principal. Got a promotion at work? Increase your monthly payments and pay your mortgage off faster. Came into some family money? Pay off the entire loan and be mortgage-free!
With an open mortgage, you can take advantage of income fluctuations to pay your mortgage off as quickly as you like.
Flexible renegotiation
Another great thing about an open mortgage is you can renegotiate the terms at your leisure. This could be beneficial if you decide you want to move and need to break your mortgage, or if a more attractive mortgage product comes along and you want to take advantage of it.
What are the cons of an open mortgage?
Higher interest rate
The trade-off with an open mortgage is that it comes with a higher interest rate than a closed mortgage. In fact, you can expect an interest rate that’s about 1% higher than a closed mortgage.
Potential for a higher cost of borrowing
Because the interest rate on an open mortgage is so much higher, it’s possible that you could end up paying more for your house over the course of the mortgage. This is especially true if you aren’t able to take advantage of the flexible prepayment options that make this type of mortgage so appealing.
Furthermore, if you can’t pay extra toward the mortgage, you might also end up having to extend the amortization to cover the additional interest.
Fewer loan term options
While closed mortgages can be negotiated for up to 10 years, open mortgages have fewer options for term lengths. Generally, the longest terms you’ll get with an open mortgage are:
- Fixed rate: 6 months to a year
- Variable rate: 3 to 5 years
Is a closed mortgage the right choice for me?
There are quite a few situations when a closed mortgage is the obvious choice. For one thing, if you have a great offer from a lender where you can lock in to a low-interest mortgage for several years and save yourself money, then a closed mortgage is probably the way to go.
Another time you might want a closed mortgage is when you don’t plan to move in the next few years, because that way you won’t have to worry about breaking your mortgage, so you can take advantage of the lower rate.
Similarly, if you don’t anticipate any other coming changes in the near future, such as with your job, income, or family status, then a closed mortgage might be the best way to get a lower interest rate and stability from your mortgage.
Should I opt for an open mortgage instead?
On the other hand, there are times when an open mortgage makes more sense, like when you know changes are coming in the future in terms of income or where you live.
For example, say you’re expecting a raise, promotion, or other positive change in your career. If you’re going to be making more money in a few months or year from now and will be able to afford larger payments, then an open mortgage gives you the freedom to increase your payments.
Similarly, if you plan to move, relocate for work, or sell an investment property, then an open mortgage provides the flexibility to break or renegotiate your mortgage without a large penalty.
That being said, it’s important to weigh this flexibility against the higher interest rate, because if you don’t take advantage of the prepayments, then it could cost you in the long run. The good news is that if plans change in an unexpected way, you can always renegotiate an open mortgage for a closed one.
Conclusion
Open and closed mortgages differ mainly in how strict or flexible they are in allowing you to make prepayments, pay off your mortgage on your schedule, or renegotiate as needed. Each has its own pros and cons, and there are different circumstances when one might be more appropriate than the other.
Another important thing to remember is that while closed mortgages have more restrictions, they tend to have lower interest rates, and they often do come with some measure of prepayment privileges.
By contrast, open mortgages offer the most flexibility in terms of paying off or renegotiating your mortgage, but they come with a higher interest rate that can cost you more in the end if you can’t make the most of the flexible prepayments.
Open and closed mortgages have their own advantages and disadvantages, and choosing the right one could save you money and help you meet your financial goals. If you’re still not sure which one is right for you, a mortgage professional can help you weigh your options.
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Over to you
Have you had an open or closed mortgage and want to share your experience? Help other Canadian homeowners make the right financial decisions by telling your story in the comments below.
