Open vs Closed Mortgages, Which is your Best Choice… Well it Depends!
Every Canadian is different, so we all have different needs when it comes to buying a home. As a result, mortgages come in lots of different shapes and sizes: closed, open, variable-rate, fixed-rate, 3-year, 5-year, 10-year… etc. etc. you get the picture.
One of the most important decisions you’ll need to make when applying for a mortgage is whether you want an open vs. closed mortgage. They are designed with different borrowers in mind and can result in significant savings (or costs) if you choose the wrong one.
In a Nutshell
Open mortgages provide you with more flexibility to prepay your mortgage, however that flexibility comes at a price… higher interest rates. A closed mortgage has lower interest rates, yet limits your prepayments and will penalize you should you need to break your mortgage.
Outside the Nutshell
What is an open mortgage?
The definition of an open mortgage is simple: the entire mortgage balance can be paid off in part or in full at any time, and the contract can be refinanced or renegotiated without penalty.
That’s what makes an open mortgage so appealing — you can pay it off early or convert to another term without a prepayment charge.
Open mortgage terms are also typically shorter than closed mortgages, ranging from six months to five years.
In Canada, open mortgages are less common. They are, however, a viable option if you are looking to pay off your mortgage early or if you want to deviate from the standard, longer-term repayment schedule.
The trade-off for the flexibility is that interest rates for open mortgages are higher compared to closed mortgage rates. With an open mortgage, you’ll likely end up paying the PRIME rate plus a substantial premium.
- The reason for this is, that lenders don’t want your mortgage for a few months or even a year… too much work and not enough profit – therefore they charge higher rates to push “rate chasers” into a closed mortgage.
What is a closed mortgage?
A closed mortgage is pretty much the opposite of an open mortgage. Closed mortgages have more restrictions and limited flexibility for borrowers: you can’t pay off the loan early, refinance, or renegotiate the terms without incurring a penalty.
On the plus side, compared to open mortgages, closed mortgages have lower interest rates.
Typically closed mortgages offer prepayment privileges, letting you boost your monthly payments by a fixed percentage. Closed mortgages also allow borrowers to pay an annual lump sum prepayment, up to a certain percentage of the mortgage balance.
- Prepayment terms are set by each lender typically ranging from 10-20% of the original mortgage balance.
Since most people are not able to pay off their mortgage quickly, closed mortgages are the most popular choice in Canada. Terms for closed mortgages can vary from anywhere between 6 months and up to 10 years.
Pros & Cons of Open and Closed Mortgages
When it comes to paying off your mortgage, you need to decide between two payment structures: an open-end and a closed-end mortgage.
- The one you choose will determine your interest rate, flexibility, and prepayment penalties.
A closed mortgage penalizes you for paying off part (or all) of your mortgage early.
Closed mortgages benefit from a lower interest rate, compared to open mortgages. Pre-payment penalties can be quite significant.
An open mortgage, on the other hand, is much more flexible in terms of increasing your mortgage repayments, which you can do either by increasing your regular payments or through a larger lump sum.
For a closed mortgage, the prepayment penalties (the cost to break your contract with your lender early) will depend on whether your interest rate is fixed or variable.
For a variable-rate mortgage, the penalty is usually three months of interest (NOT the whole mortgage payment – just the interest component).
For a fixed-rate mortgage, the fee to break your mortgages is either: three months of interest or the Interest Rate Differential (IRD), whichever is greater.
Most borrowers with a fixed rate mortgage will be paying the IRD.
- This can be a nasty surprise to Canadians who failed to read the fine print of their mortgage contract.
- It’s very important to go over your mortgage contract to find out exactly how your mortgage lender calculates IRD, each lender seems to have their own way to calculate.
The standard IRD calculation uses the difference between two interest rates: the annual interest rate in your mortgage contract, and the lender’s posted rate closest in duration to the remainder of your term.
- Most Big Banks & credit unions use the discounted IRD calculation, which uses the difference between the annual interest rate in your mortgage contract and the lender’s posted rate closest in duration to the remainder of your term, less any discount you received on your initial rate.
- As you can tell, these calculations can be confusing since each lender has their own way of calculating IRD using different interest rates. It’s best to talk to a mortgage broker about your options and clarify exactly how the IRD for your mortgage contract is calculated.
How to choose the right mortgage for you
While Canadians typically opt for a closed mortgage because of lower interest rates, an open mortgage could be a better choice for the following reasons:
1. You are about to sell your home. You might consider an open mortgage if you want to pay off your mortgage with the proceeds of selling your house.
- If you pay off a whole closed mortgage, you will likely incur significant prepayment penalties.
2. You are about to receive an inheritance/large sum of money. If you are expecting an inheritance or large sum of money, you can pay off your mortgage (all or part) with little or no penalty.
All that said, it's not just about getting the lowest interest rate — there are several variables at play when you get a mortgage.
As a Mortgage Broker, I specialize in Mortgage Intelligence, educating people about mortgages, how they work and what lenders are looking for. Everyone's home purchasing situation is different, so working with me will give you a better sense of what mortgage options are available based on the 4 strategic priorities that every mortgage needs to balance:
- lowest cost
- lowest payment
- maximum flexibility
- lowest risk
The fine print in the mortgage contract can far outweigh the rate being offered. Most people are blinded by the rate, in their quest for a mortgage.
Let’s set up a time to chat abut your home buying situation!
Kelly Hudson
Mortgage Expert
Mortgage Architects
604-312-5009
Kelly@KellyHudsonMortgages.com
www.KellyHudsonMortgages.com
