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When shopping for a mortgage, it’s easy to become overwhelmed by the terminology. Insured or conventional, fixed or variable, open or closed; all are terms you should have a basic understanding of to make the right mortgage decision. In this article, we’ll look at the difference between open and closed mortgages to help you sort out which is the best option for you.
What’s A Closed Mortgage?
Let’s start with closed mortgages, since they’re the more common of the two types. A closed mortgage simply means that during the term of the mortgage, you can’t pay off the balance in full without being charged a penalty. Even if you make a partial payment in excess of what is allowed, you’ll pay a penalty.
That’s not to say that closed mortgages aren’t flexible. In fact, most banks build prepayment allowances into their closed mortgage products. For example, a borrower can usually apply a lump sum payment of 10% – 20% to the mortgage each year without a penalty and increase their principal and interest payment amount, which is considered another form of prepayment. We’ll explain how mortgage penalties work in more detail a bit later.
Where a closed mortgage holds a distinct advantage over an open is in the interest rate. That is, a closed mortgage will almost always have a lower interest rate than an open mortgage with a comparable term. This translates into thousands of dollars of savings for the borrower over the long run. So, what a closed term mortgage gives up in flexibility, it makes up for in interest savings.
What’s An Open Mortgage?
An open mortgage is one that allows the borrower to pay off the balance in full at any time during the mortgage term without incurring a penalty. The revolving portion of a Home Equity Line Of Credit is considered an open mortgage because the balance can be paid in part or in full at any time. The flexibility offered by an open mortgage comes with a cost in the form of higher interest, which can be more than a full percent above a comparable closed-term mortgage.
When Should I Consider An Open Mortgage?
There are times when an open mortgage is the right choice and will save you money. A good example would be someone who’s selling their home in the near future and for whatever reason isn’t planning to get another mortgage right away. Perhaps they’ve chosen to rent instead, or they’re going to be travelling for an extended period. In this situation, a closed mortgage could result in a large penalty when paid out with the better interest rate being of little use.
In most cases, the interest savings offered by a closed mortgage outweighs the flexibility of an open mortgage, especially when you consider that closed mortgages almost always have some prepayment flexibility built in.
How Much Is The Penalty On A Closed Mortgage?
Prepayment penalties can vary, depending on the mortgage type, the balance that is left owing and the length of time remaining in the term. Sometimes, the mortgage is only subject to a 3-month interest charge. This is often true with variable-rate mortgages. In the case of a closed, fixed-rate mortgage, the penalty is usually the greater of 3-months interest, or something called the Interest Rate Differential (IRD).
The IRD involves a rather complicated formula, and it’s meant to compensate the lender for costs incurred if the borrower breaks the mortgage contract. Simply put, if the lender can’t turn around and lend the money to another borrower at an interest rate that’s the same or higher, the IRD will ensure that the borrower is the one who pays the difference.
I’m Thinking Of Moving, Should I Choose An Open Mortgage?
Just because you’re planning to move doesn’t mean you should automatically choose an open mortgage when it comes up for renewal. Many closed mortgages are portable, which means the mortgage lender will allow you to transfer your mortgage from one property to another without incurring a penalty. Keep in mind, there are conditions that must be followed for this to occur.
As we mentioned previously, if you’re planning to move in the near future and don’t plan to take out another mortgage, an open mortgage is likely the better choice.
When Should I Consider A Closed Mortgage?
If you plan to stay in your house for longer than 2 years, you’re almost always better off going with a closed mortgage. Because you can choose a term from 1 – 5 years or longer, you’ll be able to lock in the most competitive interest rate you can find.
If you do plan to sell and move to a nicer home but aren’t sure when, you can always hedge your bets by going with a shorter term, say 2 or 3 years. Plus, if your lender offers mortgage portability as an option, you can always transfer your closed mortgage to the new property when you move and avoid paying a penalty. However, it is important to remember that some variable mortgages are not portable and must first be converted to a fixed rate.
Final Thoughts On Open Vs. Closed Mortgages
There are three times when you’ll need to decide between an open and closed mortgage term:
- When you buy your home and first sign up for the mortgage
- If and when you ever refinance your mortgage
- Anytime your mortgage is up for renewal
In any event, the choice between open or closed will almost always come down to how long you plan to own your home. If you think you might sell in a year or less and not buy again for the foreseeable future, then an open mortgage is probably the way to go. If you’re in it for the long haul, chances are you’ll be better off saving interest with a closed term.
Tom Drake is an authority in Canadian personal finance. He is a financial analyst and has been writing about personal finance since 2009 at the award-winning MapleMoney. His work has appeared in MintLife, Canadian MoneySaver, and U.S. News & World Report, and has been quoted in The Globe and Mail, Yahoo Finance, and Financial Post.