Closed Vs. Open Mortgages: What’s The Difference?
When deciding between a closed and open mortgage, the primary consideration is whether you want lower interest rates or flexibility.
Whether you’re looking to renew your existing mortgage or a new one, you must decide whether to go for a closed or open mortgage.
Although closed mortgages sometimes attract lower interest rates than open mortgages, they are less flexible when it comes to prepayment and can be very costly if you decide to break the mortgage because of unforeseen circumstances.
Before making any selection, you should familiarize yourself with the advantages and disadvantages of open and closed mortgage options.
What is a Closed Mortgage?
Once the terms and conditions are set for a closed mortgage, they can’t be altered or terminated without attracting a penalty.
It’s up to you to decide the length of time you want to be locked into the mortgage contract or the length of time your mortgage should last. Depending on the options your lender is offering, it might range between six months and ten years. Usually, the majority of Canadians prefer a five-year period.
Your original terms permit specific prepayment options even though it’s a closed mortgage. For instance, you may be eligible to repay up to 20% of your mortgage’s initial principal once a year. Nonetheless, suppose you must sell your property or relocate before the term elapses. In that case, you may violate the mortgage terms of the contract. If this happens, you will have to pay prepayment penalties and fees.
Closed Mortgage Prepayment Penalties
The interest that remains for the duration of a closed fixed-rate mortgage, calculated by a formula known as the interest rate differential (IRD), will be placed on you if you break the mortgage. Your penalty for breaking a closed fixed-rate mortgage will increase with the length of the term you choose.
The standard prepayment penalty for breaking a closed, variable-rate mortgage equals three months’ interest.
Since closed mortgages are a mechanism for lenders to compensate for lost revenue and keep offering low-rate mortgages, the penalty for breaching one can be severe. Most homeowners choose closed mortgages because of the low-interest rates, but they are a gamble because of the prepayment penalties.
Advantages and Disadvantages of Closed Mortgages
Advantages
- Lenders may provide options for lump-sum payment or prepayment
- As opposed to open mortgages, your mortgage rates will be lower.
Disadvantages
- You can be subject to steep penalties if you must break your mortgage.
- Your ability to prepay, if it is possible at all, is limited.
What is an open mortgage?
Compared to closed mortgages, open mortgages offer a lot more flexibility. You have the option to make extra lump-sum payments at any time without incurring penalties, in addition to choosing to raise your regular payments. By doing this, you can save money by reducing the time it takes you to pay off your mortgage or your amortization period.
However, this flexibility has a price: open mortgage interest rates can be much higher than those on closed mortgages. Although paying additional interest on an open mortgage may seem like a wrong financial decision, there are certain circumstances in which it can be advantageous.
For instance, you can escape a prepayment penalty if you believe you might have to sell your house if you anticipate receiving a windfall before the expiry of the term. Nevertheless, in order to be released from an open mortgage, you might have to pay an administration fee, so make sure you read the terms and conditions before signing.
Advantages and Disadvantages of Open Mortgages
Advantages
- Making lump-sum payments is free of charge.
- There is no penalty if you decide to increase your recurring payments.
- Refinancing may be less expensive because there are no closing costs associated with it.
Disadvantages
It will attract more mortgage rates than closed mortgages.
How to Choose Between Closed and Open Mortgages
The following questions should help you decide between closed and open mortgages:
- Will I soon get a sizable inheritance or other windfall that would allow me to pay off my mortgage early?
- Am I likely to sell my home or relocate before the expiry of my mortgage term?
- Can my household income rise to the point where I can afford a larger monthly mortgage payment?
If your answer to any of these questions was yes, the right mortgage for you is an open one since it can enable you to avoid paying hefty penalties when you break your mortgage.
Alternatively, you might want to think about a short-term convertible mortgage. The average term of a convertible mortgage is six months, and its interest rates fall between those of a closed and open mortgage. A convertible mortgage allows you to extend it at the new rate whenever necessary. Then, you can lock into a longer-term option once things have settled down or interest rates have dropped.
Since most homeowners want to remain in their current residence for the duration of their mortgage, they are more than willing to accept a closed mortgage’s reduced rates. Whichever mortgage package you choose, be sure to read the terms and conditions thoroughly to avoid any unpleasant surprises should your situation or your mortgage requirements change.
Frequently Asked Questions About Open vs. Closed Mortgages
If I break a closed variable-rate mortgage, what happens?
Prepayment penalties for breaking a closed variable-rate mortgage typically are equivalent to three months’ interest. Breaking a closed fixed-rate mortgage will cost significantly more than this.
Do open mortgages offer superior terms over closed mortgages?
An open mortgage is advantageous over a closed mortgage only if it aligns with your goals as a homeowner. Although an open mortgage may cost more in interest, it is a better option if you plan to relocate, sell your house, or pay off more of it before the expiry of the term.