Open vs closed mortgage, fixed or variable rate, oh my! Are you about to buy a house for the first time? Or maybe it's time to renew? A mortgage is one of the most important decisions you will ever make; it's a serious financial and legal commitment. There are a few types of mortgages available in Canada, namely open and closed mortgages. It can be hard to know which one is best.
Open and closed mortgages vary in the way they are structured: specifically, the term, interest rate and how additional payments can be applied to the balance owing on the mortgage loan. Open and closed mortgages serve different purposes, depending on your needs and plans for the property. Let's explore an open vs closed mortgage, how it works, and which one is better for you.
- But first, what is a mortgage?
- Term vs amortization: what's the difference?
- What is an open mortgage?
- What is a closed mortgage?
- The power of prepayment privileges
- The advantage of an open mortgage
- The advantage of a closed mortgage
- What are the penalties if you break a closed mortgage?
- Are there flexible mortgage options if I have to break my term?
- Is there a penalty on a closed mortgage if I sell my home?
- Closed vs open mortgage: which one is the better for Canadians in 2022?
- FAQ About Open vs Closed Mortgages
But first, what is a mortgage?
In case you're new to the real estate game, let’s start with a basic explanation of what a mortgage is. If you want to buy a house but you don't have enough money to purchase it outright, you need to borrow money from a lender. That loan is called a mortgage.
Your mortgage is a legally binding agreement between you and the lender. They agree to lend you money at an interest rate and for a certain period of time in, called a term. In exchange, they take the title of your property. This means the lender has rights to the property should you default on your payments. Basically, as long as you have a mortgage loan, the lender owns your house too.
Term vs amortization: what's the difference?
if you sell the house, you have to pay back the remaining mortgage balance in full before ownership can be transferred from you and the lender to the new owners. A typical mortgage term usually runs three to five years.
At the end of your term, the mortgage will come up for renewal. That's when you can negotiate a new interest rate and different terms with you're existing lender. Or you can take your mortgage to a new lender without paying a penalty. Typicall, there is a penalty you have to pay if you sell the house or pay it off in full before the end of the mortgage term, but not always. More on that later.
The amortization is the total life of your loan, but the term is the specific amount of time you are committed to your lender and their terms. You will renew the mortgage several times over the amortization period, which typically runs 25 to 30 years in Canada. During the mortgage renewal, you can also make a large lump sum payment to help pay down the mortgage faster or pay it off completely without a penalty.
What is an open mortgage?
An open mortgage provides the flexibility to repay all or part of your mortgage at any time throughout the term without being charged a penalty, called the prepayment penalty. The interest rate on an open mortgage will usually be higher than the interest rate on a closed mortgage.
Open mortgages are less popular in Canada than closed mortgages. The length of term on an open mortgage can be as short as 6 months. If you are in a period of transition such as anticipating being able to pay out your mortgage in full. For example, if you plan to sell or pay off your mortgage sometime over the next six months, it's usually better to get an open mortgage.
What is a closed mortgage?
A closed mortgage is generally a longer-term arrangement of 3-5 years and will typically have a lower interest rate than an open mortgage. It has more restrictions and offers less flexibility to make additional payments during the life of the mortgage. Canadians tend to prefer closed mortgages because they offer better mortgage rates.
While borrowers cannot repay a close mortgage in its entirety when they feel like it, most closed mortgages come with prepayment privileges. Those are determined by your lender and typically allow for an additional lump sum payment to be made on the anniversary of the mortgage.
The power of prepayment privileges
If you are able to pay a lump sum on the anniversary of your mortgage, do so! Consider that you are able to put an additional $5,000 payment on your mortgage every time it comes up for renewal; about 5 times over the life of your mortgage loan.
You would lower the principal amount of the mortgage by $25,000 and pay off your mortgage that much sooner. That offers great savings on interest charges over the entire amortization period; the time which you have the mortgage on the property. It’s quite a privilege to be mortgage free!
The advantage of an open mortgage
An open mortgage may be a good choice if you:
- plan to pay off your mortgage soon, typically within a six-month time frame
- are considering selling your home in the near future
- think you may have extra money to put toward your mortgage from time to time
The advantage of a closed mortgage
A closed mortgage may be a good choice for you, if:
- you plan to keep your home for the full term of your mortgage
- the prepayment privileges provide enough flexibility for the extra payments you can afford to make
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What are the penalties if you break a closed mortgage?
There are penalties if you have to break a closed mortgage term. Prepayment penalties are based on whether your mortgage interest rate is fixed or variable. The penalties can be three months of interest or calculated as the “Interest Rate Differential.”
What kind of circumstances might cause you to break a closed mortgage, but still be worth paying penalties? Examples include, but are not limited to:
- Interest rates have decreased. Getting a new mortgage may make sense even when factoring in the penalty.
- Changes to your family situation. If you have kids or experience a breakup, you may need to sell or get a new mortgage.
- You are facing financial uncertainty. If your finances have taken a hit you may need to re-mortgage.
The major banks in Canada have Mortgage Penalty Calculators on their websites. That way you can calculate the penalty ahead of time to determine if it is a price worth paying.
Are there flexible mortgage options if I have to break my term?
There are some additional mortgage products to be aware of that provide flexibility when it may seem like breaking your mortgage is the only option. There are “blended” or blend-and-extend mortgages. These are valuable in situations where you may have to break your mortgage or may be able to take advantage of an early renewal option.
These options will be practical if you stay with the same lender. A blended mortgage option is unlikely to be agreeable to your current lender if you are switching lenders in this process.
Is there a penalty on a closed mortgage if I sell my home?
While Canadians tend to settle into their homes for the longer term, moving remains an option for many people. The chances of timing a move to coincide with the end of your mortgage term in a white-hot real estate market are next to impossible. People may move because of a career change, relationship break-up or a need to up-size or down-size. Or they may just want to find a lower cost of living area.
Say you want to sell your house, buy a new one, and stay with the same lender too. You can transfer your existing mortgage to a new property! The process of transferring a mortgage from one property to another during the term is called “porting”.
It is important to know the rules, conditions, and potential penalties of porting before you get into a closed mortgage. Make sure your lender or broker has clearly explained these rules to you when you agree to the terms of the mortgage. It can be very costly to overlook this condition of your closed mortgage. The penalties you incur may be very costly.
Closed vs open mortgage: which one is the better for Canadians in 2022?
An open vs closed mortgage, which one is better? For the vast majority of Canadians, a closed mortgage is the better option. As most of us will amortize our homes over a 25-30 year time frame, the lower interest rate will save money. The “prepayment privileges” within a closed mortgage do allow additional payments on the original amount of the mortgage. This gives Canadians the freedom to pay down their mortgage faster, avoid the penalty, and still get the lower rates in a closed mortgage.
Read More: Fixed vs Variable Rate Mortgages in Canada
The open mortgage does offer advantages in specific situations, like if you plan to sell within 6 months to a year. These cases may be events such as only holding the property while it is being renovated, like house flipping, or if the balance owing on the mortgage can be paid off in under two years.
FAQ About Open vs Closed Mortgages
An open mortgage is one with flexible options to increase your mortgage repayments, either by increasing your regular payments or via a lump sum. But it typically comes with a higher interest rate.
A closed mortgage, on the other hand, may have prepayment privileges that dictate when you can make additional payments, and how much. Otherwise, you will be penalized if you pay off all or part of your mortgage early, before the end of your term. While prepayment penalties can be significant, closed mortgages also come with much lower interest rates than open mortgages.
A fixed open mortgage has high-interest rates because it offers the opportunity to lock in a particular rate and still allows you to make extra payments or pay off the full balance of the mortgage. These mortgages are only available on short terms of 6 to 12 months.
An open mortgage can have a shorter term of 6 months to two years and will have higher interest rates, but it does allow you to pay off the mortgage in full at any time without penalties. Whereas a closed mortgage will have a longer term, usually 3-5 years, lower interest rates, and only allow for specific prepayment privileges.
In a variable closed mortgage, the interest rates may be variable but the repayment terms of a close mortgage are not. This is where you must read the fine print as you can break the mortgage but it comes with a penalty of 3 months interest on the remaining balance of your mortgage.
A five-year variable mortgage is all in the name, a five-year mortgage that does have variable rates. It is for people who are certain they are staying in their home for the duration of the mortgage term. The penalty to break it early would be high and so it is not a good choice for people who may be on the move.