22 Mar Closed vs Open mortgages
Are you looking into getting a mortgage and are not sure whether or not to get a closed or an open mortgage? That is very common. When choosing a mortgage, it is very important to be informed about all the options available. In this post, we will address the difference between these two terms.
In simple terms, a closed mortgage is one that cannot be repaid without prepayment penalties during its term, except as outlined in the mortgage agreement. Closed mortgages generally have lower interest rates due to the penalty factor. With a closed mortgage, you are essentially agreeing to keep the loan for the entire term, as they provide limited prepayment privileges. The prepayment penalty will apply if the borrower exceeds the allowed prepayment privileges when increasing the monthly payments. Break fees are generally either the sum of three months of interest on your mortgage or the interest rate differential (also known as IRD), whichever is greater. The IRD is the difference between what you would have paid in interest and what the bank can now make on the funds they lent you, based on the current rates, for the remainder of your term.
Despite prepayment penalties, a closed mortgage has advantages. If you do not intend to sell the property in the foreseeable future, have no intention of prepaying any portion of the mortgage over an above what is allowed in the pre-payment privileges or have no intent to refinance the mortgage during the term, a closed mortgage may make financial sense. Many closed mortgages are fixed rate mortgages (see our blog post on this topic), and if the prevailing mortgage rates are low when the mortgage is issued, the borrower has then locked in at a low interest rate, a good protection against rising interest rates.
An open mortgage gives homeowners the flexibility to pay off their mortgage at any time without penalties. However, open mortgage rates are usually variable and a little higher. You’ll likely end up paying the prime rate plus a substantial premium. On the other hand, you can always move into a regular fixed rate mortgage if you decide variable interest rates aren’t a good fit for you.
Open mortgages can be very beneficial for people with variable income, such as borrowers who are self-employed. If this person receives extra money at any given time, he or she may then apply it to the mortgage principal without interest. It may also be beneficial for people who are expecting an increase in income in the future, and who will desire to repay as much of their mortgage as fast as possible. An open mortgage will allow the borrower to do so, without penalty, and the more applied to principal, the less interest the borrower will eventually pay on the mortgage.