What’s the Difference Between Open and Closed Mortgages?
Whether you’re signing up for a new mortgage or renewing for another term, you’ll need to make a decision: do you go with a closed or open mortgage. While a closed mortgage is the most common type in Canada, there are times when an open mortgage, or even a convertible mortgage, makes more sense. In this article, I’ll explain the differences between each type and help you make the best decision for your mortgage. Ready? Let’s dive in!
What Is A Closed Mortgage?
A closed mortgage cannot be paid in full before the end of the term without a penalty. A closed mortgage can have a fixed or variable interest rate. For many years, the most common closed mortgage term in Canada has been the 5-year fixed rate.
There are two types of penalties that lenders can charge on a closed term mortgage, should you choose to break the term contract early, namely, the Interest Rate Differential charge (IRD) and a 3-month interest penalty. The latter is pretty straightforward (calculate 3-month’s worth of interest and charge it), while the former is more complex.
While different lenders calculate the IRD in different ways, it’s designed to recuperate the lender for costs resulting from the borrower breaking the contract in the middle of the term. If current interest rates are lower than the mortgage rate, the IRD can be very expensive, especially early in the term. Towards the end of the term, the 3-month interest penalty is often the higher of the two.
Why is this distinction important? Because in almost all cases, your lender will charge whichever penalty amount is higher – IRD or 3-month’s interest.
When Does a Closed Mortgage Make the Most Sense?
The main benefit of a closed mortgage is that it offers a lower interest rate than an open mortgage, which we’ll explore next. Because a mortgage is the largest loan, most people will ever have, securing the lowest possible rate is highly advantageous.
For this reason, it makes the most sense to choose a closed mortgage if you plan to stay in your current home for several years and you don’t anticipate having the ability to pay off the mortgage balance in full during that time.
The drawback of a closed mortgage is that it lacks flexibility. Once you are locked in, you can’t pay off the mortgage in full without incurring a penalty until the term expires. If you choose a 5-year term, the lender is locking you in for a full 60 months.
As I mentioned earlier, the penalties on a closed mortgage can be very steep, so you need to be comfortable locking in for the full term. Of course, you can always opt for a shorter term. In Canada, closed mortgage terms start at one year and can go as long as ten years.
Can I Prepay A Closed Mortgage?
Just because you can’t break a closed mortgage without incurring a penalty doesn’t mean there is no flexibility. Most lenders do allow for various forms of prepayment during the term, up to a specific limit.
This can include annual lump sum payments of between 10% and 20% of the original mortgage principal, increased to the periodic payment amount, as well as a weekly or biweekly rapid payment option. Before you sign up for a closed mortgage, you should check with your lender to find out what your prepayment options will be.
What Is An Open Mortgage?
An open mortgage offers more flexibility to the borrower than a closed mortgage. In most cases, there is no penalty to pay off an open mortgage during the mortgage term. The borrower can make prepayments in part or full without fear of incurring an Interest Rate Differential charge or a 3-month interest penalty. An open mortgage can be either a fixed or variable rate.
If you do sign up for an open mortgage, you should still read the fine print. Some lenders may still charge an administration fee if you pay off an open mortgage early, so ensure you understand all of the conditions before signing up.
When Does An Open Mortgage Make Sense?
The interest rate on an open mortgage is always higher than a fixed mortgage rate of the same term. If that’s the case, why would anyone go for an open mortgage? The main reason is that they plan to pay off the mortgage in full within a reasonable time frame. Here is a list of events that might lead you to pay off your mortgage in full:
- Selling your home
- Going through a marital split
- You receive a large lump sum of cash (i.e., inheritance, lottery win)
Another reason is that you believe interest rates will fall in the near future, so you’re willing to pay a premium for the flexibility of locking into a potentially lower rate in the future.
What Is A Convertible Mortgage?
A convertible mortgage falls in between an open and closed mortgage. It provides the borrower with a fixed interest rate and the option of converting into a new mortgage term before the current term expires. The new mortgage term must be longer than the existing term. Often, a convertible mortgage is available in a 6-month term, with the borrower having the option to convert to a 1,2,3,4, or 5-year fixed term without incurring a penalty.
When Does A Convertible Mortgage Make Sense?
There are a couple of instances where a convertible mortgage may be the right choice.
The first is if you think interest rates are on the way down, you have the option of converting to a longer-term if and when that happens. In the meantime, you avoid having to commit to a higher interest rate long-term.
Second, if you plan to sell your house very soon, say, six months or less, then a six-month convertible mortgage might be suitable. While many borrowers will opt for an open mortgage in this situation, the interest rate on a convertible mortgage is usually lower than an open, making it a reasonable alternative.
The third reason you might opt for a convertible mortgage is if you are very close to paying off your mortgage. For example, you have six months or less remaining, but you aren’t prepared to pay off the balance in full with a single lump sum. Instead, you could ride a 6-month convertible mortgage to the finish line.
Final Thoughts on Open vs. Closed Mortgages
In almost all cases, Canadian home buyers opt for closed mortgages for the simple reason that they offer the lowest interest rates. This is true whether you choose a variable rate or a fixed rate. However, there are times when an open mortgage is the better choice – you’re planning to move, going through a marital split, you think interest rates may be headed downwards soon, or you’re expecting a large windfall of cash and plan to pay off your mortgage. If any of these possibilities apply to you, make sure you do your homework before signing your next mortgage contract.