WHAT ARE OPEN AND CLOSED MORTGAGES
In this article titled; What are open and closed mortgages, we shall discuss the following topics:
1) What is a Closed Mortgage?
2) What is an Open Mortgage?
3) How do rate compare between Open And Closed Mortgages?
4) Which One is right?
5) How much are Prepayment Penalties.
When you are looking to get a mortgage, you may be overwhelmed with all of the different terminologies that can come into play when choosing what is best for you. There are a lot of different options and they all make a difference in how your mortgage works.
In the past, we have looked at topics such as mortgage rates, stress tests, mortgage renewals, and more. But, believe it or not, there is still more work to be done in explaining the wonderful (or, wonderfully complex) world of mortgages.
Today, we’re going to cover a mortgage option that may be less common but it’s an important distinction to know. It’s something that will be a great option for some people and not so great for others: open and closed mortgages. The two terms ‘open’ and ‘closed’ paint a pretty clear distinction, but what exactly do they mean in practice and when should you choose one or the other?
1) What is a closed mortgage?
Closed mortgages are generally the more popular option in Canada. Essentially, when we talk about open vs. closed mortgages, we are talking about when you are allowed to end or change your mortgage contract. Every mortgage has a period of time over which you have agreed with your bank to pay back your mortgage. Your bank expects you to have paid a certain amount by the time the term expires, but they are also counting on earning money from your interest until then. You might think when you lend someone money you’ll want it back as soon as possible, but this isn’t the case for banks that make more money the longer you have debt.
A closed mortgage is basically a mortgage that you cannot pay back early without some kind of prepayment penalty. As mentioned, this option is pretty popular and that’s because most people do not plan on paying off their mortgage sooner. Plus, many couldn’t even if they wanted to. A closed mortgage also prevents the owner from refinancing or renegotiating mortgage terms without a similar fee. The fee you may be required to pay isn’t small either. The cost will vary between lenders but will be based on a number of factors such as how much is left of your mortgage principal, the mortgage term length, and your interest rate. We will explore more later about how much you can expect to be charged for a prepayment penalty.
There is some flexibility in closed mortgages, however, as many lenders will allow you to prepay your mortgage by increasing your monthly mortgage payments, but only by a set percentage – usually up to 10%. In general, closed mortgages often have lower interest rates than open mortgages as the bank is more confident that they will be able to get their expected interest amount from you.
2) What is an open mortgage?
In contrast to a closed mortgage, an open mortgage does not put any penalties or limitations on how soon you can pay back your mortgage principal. You are also free to refinance or renegotiate your mortgage contract at any time.
These mortgages will have similar conditions including an agreed-upon mortgage term, amortization period, and set monthly payments, but there is no requirement to wait to pay off your mortgage. In addition, open mortgage terms tend to be shorter and have fewer options available than closed mortgages.
This added flexibility can be a benefit to some people. For example, if you expect your income to increase greatly in the short term or are expecting to get a large payout from a work bonus, inheritance, or another financial windfall. It can also be a good option if you believe you will need to refinance or sell in the short term and don’t want to be hit with a penalty.
However, with the added flexibility comes a price: open mortgages tend to have much higher interest rates than closed mortgages. Your bank has no guarantee that you will pay interest for as long as they want you to. In fact, by opting for an open mortgage, they have reason to believe that you likely will break your mortgage contract at some point. As a result, they will charge you a bit more in interest to cover the added risk and reduced profits.
3) How do rates compare between open and closed mortgages?
As mentioned before, open mortgages tend to have higher interest rates than closed mortgages, but just how much do the rates vary?
Just looking at one example, a one-year fixed-rate closed mortgage at RBC currently has a mortgage rate of around 3.8%. The open mortgage option for the same term has a whopping 8.3% interest rate. That means you will pay more than double in interest for the flexibility of early repayment.
For some, this may be worth it, but this should at least prove why you need to understand the difference between the two. If you take an open mortgage that you don’t need, it can end up costing you a lot more money.
4) Which Is right for me?
So, now that you know what the difference is between an open and closed mortgage, you may still be unsure about which one is right for you.
In most cases, a closed mortgage will be the best choice. These are the most popular types of mortgages in Canada and for good reason. If you don’t expect to be in the position to pay off your mortgage in full any time soon and are not expecting a sudden windfall, you should simply go with the closed mortgage option. This will provide you with the best interest rates as well as the most options when it comes to mortgage terms. With a closed mortgage, you can save a lot on your interest rate and you may still even be able to pay off a small amount of your mortgage early through prepayments.
The cases in which you should go for an open mortgage are more specific, but in these rare cases, they are a great option. An open mortgage is a good idea if you plan on moving in the short term or are expecting to get a significant amount of money soon to pay off your mortgage early. Keep in mind that you will be paying much higher interest rates. This means you need to look to the short term to decide if you should get an open mortgage. If you think you will be able to pay your mortgage early, you may just end up paying more in interest than you would if you simply paid your prepayment penalties on a closed mortgage.
Ultimately, every buyer’s circumstance will be different and if you have any doubts you should speak to a mortgage broker or financial advisor to better help you understand what may be best for your personal financial status before you agree to any mortgage.
5) How much are prepayment penalties?
One of the important factors in considering whether you should get an open or closed mortgage will be just how much your prepayment penalties would be if you were to hypothetically pay off your mortgage early. Depending on how soon you plan to pay off your mortgage and how much your penalties would be, it may be more worth your while to opt for one or the other. But, just how are these penalties calculated?
In general, the amount of your penalty will depend on a few factors including:
How much you wish to prepay on your mortgage?
How many months are left on your mortgage term
Your current interest rate
Current interest rates offered by your lender
In most cases, banks will set your penalty at the greater of two numbers. The first of these is the value of three months’ interest on how much you plan to prepay (or how much money is left on the loan if you prepay in full). The other is what is known as the interest rate differential (IRD) on the amount you prepay. While the first one may seem easy to calculate, the IRD may require some more explanation.
The IRD is the difference between two amounts based on two different interest rates. The first is the value of your interest for the remainder of your term at your current interest rate. The other is the remainder of interest at the bank’s own current posted rate for a mortgage of the same length. This means if you had two years left on your term, your bank would use their two-year mortgage rate.
To help illustrate, here is an example:
Say you have an outstanding mortgage balance of $250,000 at an interest rate of 5%. You have 36 months left in your five-year term. At this point, you decide to pay off your mortgage. Three months of interest on this mortgage would cost you around $3,000.
If your bank offers a 4% interest rate on a three-year (36-month) mortgage, the IRD would come out to $7,500. Because that is the higher number, this would be your penalty. Prepayment penalties can easily cost above $10,000 depending on your remaining principal and interest rates.
Though these calculations may seem a bit hard to work out, each lender should offer a mortgage penalty calculator online that you can reference. For more information, consider speaking directly to your lender or a mortgage professional to help answer any questions you may have.
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You should always determine how much you stand to be charged in penalties before you choose to prepay or break a closed mortgage contract.