Finding the right mortgage type involves making a lot of decisions. One important decision you’ll face is whether to choose an open or closed mortgage.

Both have advantages and drawbacks, so your choice should align with your plans for the home as well as any potential changes to your personal finances.

Let’s take a deep dive into closed and open mortgages, how they differ, their pros and cons and when you should choose one over the other.

What’s A Closed Mortgage?

In a closed mortgage, the terms and conditions agreed upon by the lender and borrower are set (or “closed”) for the duration of the mortgage term. 

This means that during a given term, borrowers can’t increase their monthly mortgage payment amount or repay the mortgage in full without incurring a prepayment penalty. 

However, some lenders offer specific prepayment privileges, which allow borrowers with a closed mortgage to make a lump sum payment of up to 10% – 20% of the loan’s original principal amount per year without triggering a penalty. Prepayment privileges vary by lender, so it’s important to understand the options laid out in your contract.

Despite their prepayment limitations, closed mortgages tend to be the more popular choice among Canadian homeowners because they typically come with a lower interest rate than an open mortgage with a comparable term.

How Much Are Prepayment Penalties On A Closed Mortgage?

Your lender will charge you a prepayment penalty if you break a closed mortgage contract. For example, you’ll get hit with a penalty if you exceed your prepayment privilege amount, renegotiate the conditions of your mortgage or switch lenders in the middle of a term.

The penalty amount will depend on a few variables, including whether you’re breaking a variable- or fixed-rate mortgage. Typically, the fee for breaking a closed variable-rate mortgage is 3 months’ worth of interest on your loan. 

The prepayment penalty for breaking a closed fixed-rate mortgage will be either 3 months’ worth of interest or an amount based on something called the interest rate differential (IRD), whichever is higher. 

The IRD is essentially a formula used to calculate the difference between your mortgage rate and current market rates. The formula also takes into account your remaining principal balance, as well as the amount of time you have left in the term you’re breaking. As a result, breaking a closed fixed-rate mortgage earlier in the term will generally lead to a higher penalty when based on the IRD.

What’s An Open Mortgage?

As the name suggests, an open mortgage comes with greater flexibility, or “openness”, than a closed mortgage. With an open mortgage, borrowers may break or renegotiate the conditions of their contract (including interest rates) without penalty.

Specifically, an open mortgage allows borrowers to increase their monthly mortgage payment, make lump-sum payments toward their principal or even repay their mortgage in full in the middle of a term – all without a prepayment penalty. By taking advantage of these options, you could potentially shorten your mortgage’s amortization period and save on interest over time. 

In exchange for this flexibility, open mortgages typically come with higher interest rates than closed mortgages. Depending on your financial situation and any potential plans to sell your home, the added flexibility of an open mortgage may or may not be worth the higher interest rate.

Choosing Between An Open Or Closed Mortgage

There are three times when you’ll need to decide between an open and closed mortgage term:

In addition to the basic pros and cons of open and closed mortgages, there may be other factors that affect your decision. Let’s have a look at what to keep in mind when choosing between open and closed mortgage options.

When To Consider A Closed Mortgage

  • You want a lower interest rate.
  • You plan to own your home for the entire mortgage term.
  • You don’t have the need, desire or ability to pay your mortgage off before the end of your current term.
  • Any additional payments you want to make will fit within the prepayment privileges offered on a closer mortgage.

Even if you decide to move homes in the middle of a term, you may be able to avoid a prepayment penalty if your lender offers mortgage portability. This allows you to transfer your existing mortgage to a new property. However, some variable-rate mortgages aren’t portable and must first be converted to a fixed-rate loan.

When To Consider An Open Mortgage

Even though open mortgages come with higher interest rates, there are times when they might make financial sense for your situation. For example, you may consider an open mortgage if:

  • You intend to sell your home soon and don’t plan to take out another mortgage.
  • You want to pay off your mortgage in full before the end of a term.
  • You’re expecting an increase in income or to receive a sum of money (e.g., an inheritance or insurance payout) and would like to use these funds to make larger or additional payments against your mortgage.
  • You plan to be in a mortgage for a very short period of time and there is no financial benefit to being locked into a closed mortgage and being charged a penalty.

In these situations, the money you save by avoiding prepayment penalties might be worth whatever additional interest you pay on an open mortgage. It’s important to do the math and make sure the option you choose will work in your financial favour.

The Bottom Line

The choice between an open and closed mortgage will often come down to how long you plan to own your home. If you plan to sell your home soon without taking out a new mortgage or want to pay your mortgage off early, an open mortgage might suit you well. However, a closed mortgage could save you money in the long run if you plan on owning your home for the foreseeable future.

If you want to view your mortgage options, get started today with Rocket Mortgage Canada, UL (Rocket Mortgage™).