The main difference between open and closed mortgages is that there are no prepayment penalties on open mortgages.
|Open Mortgage||Closed Mortgage|
|Prepayments||Prepayments are allowed with no restrictions||Prepayments are not allowed without payment of a prepayment penalty; partial prepayments are allowed on some mortgage contracts|
|Term length||Six months to five years||Six months to ten years|
|Refinancing||Flexible and cheap; no payment of penalty required||Restrictive and expensive; payment of penalty required|
|Key Benefit||Prepayments are allowed with no penalty||Low-interest rates|
|Key Risk||High-interest rates||Payment of prepayment penalty is required to break mortgage contract|
What is an Open Mortgage?
An open mortgage provides you with the flexibility to make additional payments during your mortgage term without incurring a prepayment penalty.
You can either increase the size of your regular payment or pay a lump sum amount at your discretion.
Lenders assign higher interest rates to open mortgages.
The reason is that they may lose out on considerable interest revenue should a homeowner decide to accelerate the pace at which they pay down their mortgage.
As compensation, they add a premium on top of open mortgage rates.
Open mortgages aren’t as prevalent as closed mortgages; the higher interest rate is enough to discourage most homeowners.
They’re available with terms ranging from six months to five years.
Is It Right for Me?
Open mortgages appeal primarily to homeowners who value the freedom of contributing additional payments toward their outstanding balance to become mortgage-free faster.
They’re willing to pay a higher interest rate for this privilege and content with larger monthly payments.
An open mortgage is ideal also for those who anticipate selling their home before their term’s ending date.
They can use the proceeds from the sale of their home to settle the outstanding balance without needing to pay a hefty prepayment penalty.
On the other hand, an open mortgage would not suit an individual or household operating with a tight budget, as the inflated mortgage payments could strain them financially.
Open mortgages come with short terms, so individuals seeking to lock in a favourable interest rate for ten years should opt for a closed mortgage.
What is a Closed Mortgage?
With a closed mortgage, your ability to increase your regular payments or to make any lump sum contributions will be clearly defined in your contract.
In many instances you are allowed to increase your regular payments by a certain percentage or make a yearly lump sum payment equal to a certain percentage of the principal outstanding.
In other cases, you have no ability to make any additional payments.
Regardless of the above terms, you cannot pay off your closed mortgage before the term ends without incurring a prepayment penalty.
Since lenders have a greater assurance of collecting steady interest payments for many years, they’re more inclined to charge low rates on closed mortgage contracts.
When it comes down to choosing between an open and a closed mortgage, most homeowners opt for the latter.
A closed mortgage with a lower rate translates to less interest paid and lower payments overall, which is this mortgage type’s primary selling point.
Closed mortgages are available with terms of up to 10 years.
Is It Right for Me?
Closed mortgages are ideal for homeowners looking to minimize their housing costs, as they come with lower interest rates.
They’re a popular option with those who prefer a stable payment schedule and adhere to a strict budget.
A closed mortgage is also an excellent option for homeowners committed to living in one location for a lengthy period.
Since they’re unlikely to sell their home in the immediate future, they can obtain an extended mortgage term that will provide them with smaller monthly payments.
Conversely, a closed mortgage would not work with a household whose goal is to pay down debt as fast as possible.
Nor would it appeal to homeowners who intend to live in their current home only briefly and wish to avoid the prepayment penalty once they sell it.
Prepayment Penalties on Closed Mortgages
You will trigger a prepayment penalty on a closed mortgage if you:
- Refinance your mortgage before your term’s maturity date
- Apply an additional payment(s) beyond what’s allowed as per your mortgage contract.
- Move your mortgage to another financial institution before your term’s maturity date.
- Pay off your mortgage before your term’s maturity date.
Lenders impose a prepayment penalty on fixed-rate closed mortgages and variable-rate closed mortgages.
The amount you’ll be responsible for paying will depend on which type of mortgage you hold.
For a fixed-rate mortgage, lenders usually assess the penalty as the greater of:
- The interest rate differential (IRD), and
- Three-months interest
The IRD represents the interest revenue your lender would forfeit should you break your mortgage.
Lenders typically calculate it in the following way:
- Determine the difference between your contracted mortgage rate and the rate they currently offer to borrowers.
- Multiply the result by your remaining principal and divide the result by 12 to get the monthly fee.
- Multiply the monthly fee by the number of months left in your term
The three-month interest penalty is self-explanatory: it’s simply the equivalent of three months’ interest on your outstanding balance.
In an environment where interest rates are falling, there’s a greater chance your contracted mortgage rate will exceed your lender’s current rate offering.
If that’s the case, your lender will base your penalty on the IRD, which can be quite steep if rates have declined considerably.
Alternatively, if interest rates are rising, your contracted mortgage rate is more likely to be lower than what your lender offers to new borrowers.
In this case, your IRD will be negative, which means it doesn’t apply to your lender’s calculation. By default, they’ll assess your penalty as three months’ interest, which is typically more affordable than the IRD.
You pay a lower penalty because your lender can readvance the funds from your mortgage to a new borrower at a higher rate.
The IRD calculation doesn’t come into play for a variable-rate mortgage – your lender will levy a fee based on three months’ worth of interest charges.
Keep in mind that each lender might have its unique formula for calculating the prepayment penalty, especially the IRD.
A convertible closed mortgage functions like a closed mortgage, but the borrower has the option to extend the term without incurring a prepayment fee.
Frequently Asked Questions
- Can you pay off a closed mortgage early?
Yes. It’s entirely within your contractual right to pay off your closed mortgage before your term expires. However, the action will trigger a prepayment penalty.
Depending on your remaining balance, the time left in your term, the conditions in your contract, and various other factors, this penalty could be exceptionally high. In some cases, the cost of paying off a closed mortgage early outweighs the benefits.
- What is a 1-year open mortgage?
A one-year open mortgage is a mortgage product with a term spanning one year. It offers the borrower the flexibility to apply additional payments toward the balance without incurring a prepayment penalty.
However, this type of mortgage comes with a steep interest rate, which the lender assigns to price in the risk of lost interest revenue should the borrower pay the mortgage early.