HomeSelecting the correct mortgage type plays a crucial role in financing your home purchase. It’s essential to understand the differences between the mortgage types so you can pick wisely based on your financial situation. A key decision in the mortgage selection process is the decision to opt for an open or closed mortgage.
The distinction between open and closed mortgages lies in their payment flexibility. Open mortgages permit additional payments and early repayment without penalties, whereas closed mortgages have stricter terms and lower interest rates. It is important to know when each type is optimal as a wrong selection can prove costly.
What is a closed mortgage?
Closed mortgages provide home buyers with a one-time lump sum to finance their home purchase. This loan is then repaid through fixed payments as outlined in the mortgage contract. Due to the stability offered by closed mortgages, lenders can offer lower interest rates compared to open mortgages. However, homeowners should be aware that making additional lump sum payments or increasing their regular mortgage payments may result in pre-payment penalties. While closed mortgages provide some flexibility, it is limited in terms of prepayment options.
Given that lenders anticipate borrowers to adhere to their mortgage terms, penalties for violating these terms can result in significant costs for homeowners. If you break a closed fixed-rate mortgage, you can expect penalties based on an interest rate differential (IRD) calculation, which requires you to pay the interest for the remaining term. Meanwhile, breaking a closed variable-rate mortgage typically incurs a prepayment penalty equivalent to three months’ interest.
What is an open mortgage?
An open mortgage offers homebuyers flexible payment options, often allowing for lump-sum payments toward the principal or increased regular mortgage payments. This flexibility empowers homeowners to save money by paying off their mortgage sooner, all while avoiding prepayment penalties. However, it’s worth noting that open mortgages typically come with higher interest rates compared to closed mortgages. Despite this, an open mortgage can still be advantageous in specific circumstances.
Quick comparison: Closed mortgage vs. open mortgage
Regular mortgage payments: An open mortgage allows you to increase your mortgage payments with little to no penalty — you are unable to increase your mortgage payments with a Closed mortgage without refinancing.
Lump-Sum payments: Expecting a windfall? An open mortgage will let you make lump-sum payments with little to no penalty — If you pick a closed mortgage a lump-sum payment will cause you to incur a penalty.
Refinancing your mortgage: If you want to refinance an open mortgage is both cheaper and more flexible — the reverse is true with a closed mortgage as refinancing will be both more expensive and difficult.
Mortgage Rates: Open mortgages charge a premium on their interest rates with all of the flexibility the lenders allow for — While the fixed terms of a closed mortgage allow the borrower to benefit from lower mortgage rates.
How to pick the right mortgage type: open vs. closed mortgages
The closed mortgage is the preferred choice for Canadian homeowners, especially when the flexibility of an open mortgage isn’t necessary. With lower interest rates, those who anticipate making standard payments can save on interest costs over the mortgage’s lifespan.
Homebuyers who anticipate making extra payments beyond the standard outlined mortgage payment may find significant value in the flexibility of an open mortgage, even with its higher associated interest rates. Here are some situations where an open mortgage could be advantageous:
- You are looking to sell your home: If you plan to sell your home in the future and use the proceeds to pay off the mortgage, a closed mortgage could result in substantial prepayment penalties. In contrast, an open mortgage allows you to pay off the mortgage in full without any penalties.
- You are expecting a windfall: If you anticipate a substantial influx of funds from an inheritance, bonus, tax refund, or the sale of a personal item, opting for an open mortgage enables you to utilize the windfall to pay down a portion of your mortgage while incurring little to no penalties.
- Your Income is about to increase: If you anticipate a promotion or new employment that will boost your household income, opting for an open mortgage provides the flexibility to increase your mortgage payments without incurring any penalties.
- A volatile mortgage market: If you anticipate the need for adjustments to your mortgage term within a short timeframe, an open mortgage can offer greater flexibility compared to a closed mortgage.
Final thoughts: Which type of mortgage should you pick?
The difference between closed and open mortgages lies primarily in their payment flexibility and interest rates. Closed mortgages offer limited payment flexibility, which translates to lower interest rates. On the other hand, open mortgages provide greater payment flexibility but come with higher interest rates. When deciding on a mortgage type, it’s crucial to consider your financial goals and risk tolerance. Making an incorrect choice — opting for an open mortgage when a closed one would be more suitable — could result in thousands of dollars in additional interest or pre-payment penalties.