Open or Closed Mortgage?
When shopping for a mortgage you might have noticed that closed mortgage products offer lower interest rates compared to open mortgage products. Why is that?
What is a Closed Mortgage?
It’s really quite simple, closed mortgages cannot be prepaid, renegotiated or refinanced before maturity without paying a penalty. Most closed mortgages do a bit of flexibility by allowing you to repay the principle through lump sum payments, or by increasing your monthly payment amount. If you haven’t guessed, this type of mortgage is a bit more restrictive which is why they generally offer lower rates.
When to Consider a Closed Mortgage
Since closed mortgages have significantly lower interest rates than open products, they are more attractive to the average home-buyer as long of course no major changes are anticipated in the near future.
When NOT to Consider a Closed Mortgage
If you think that you might need to break your mortgage early - say you’re planning on selling your home and want to move into a new mortgage, or perhaps you’re planning on winning the lottery and paying off your home in cold hard cash (we can all dream) - you might want to avoid a closed mortgage so you can avoid paying those hefty penalties.
What is an Open Mortgage?
Open mortgage terms range from 6 months to 1 year for fixed rates, and 3 to 5 years for variable rates and can be paid off before maturity without penalty. Some open mortgages also allow you to convert to a closed mortgage without any penalty if needed.
When to Consider an Open Mortgage
An open mortgage might be a good choice for you if you’re expecting a large sum of money either through an insurance claim, divorce settlements, inheritances or winning that lottery, without any penalties.
The Beauty of Prepayments with Closed Mortgages
Let’s be honest, not too many people have to worry about paying off their mortgage in one lump sum, but it’s not uncommon to have a bit of cash saved up and wonder how you can use it to pay down your mortgage faster. Most closed mortgages do offer prepayment options, including: lump sum payments up to a percentage of your principal each year, or increasing your monthly mortgage payment by a certain percentage.
A lender may offer the following pre-payment privileges on a 5 year closed fixed mortgage:
- Lump Sum: 15% lump sum payment each year
- Increase Payments: 15% increase to the monthly payments
Based on a $250,000 mortgage, amortized over 25 years at 4.0%, with monthly payments of $1315, you could:
- Lump Sum: contribute up to $37,500 extra in your first year (this amount will decrease as the principal decreases)
- Increase Payments: increase your mortgage payments by $198 per month to $1512.
How much does a Closed Mortgage Penalty cost?
If you do decide to break your closed mortgage before the end of your term, you could face paying a penalty. The penalty you pay is the greater of: three months of interest, and the Interest Rate Differential (IRD).
Interest Rate Differential (IRD): the difference between today's interest rate and the rate you pay. Take the difference between the two rates, multiply it by your balance and then by the remaining number of months in your term. The earlier in your term, the larger the penalty will be. Note that IRD calculations vary slightly depending on the lender.