If you’re buying a home, whether it be your first or your third, chances are you’ll need to take out a mortgage. For the uninitiated, this can be a confusing time. Mortgages come in a number of shapes and sizes: fixed rate, variable rate, adjustable and, finally, open or closed.
This choice can be overwhelming, but knowledge is power! So we’ve created a series of mortgage specials that take a look at the various options open to you. In this final part, we’ll discuss the difference between open and closed mortgages, and which might be the best fit for you.
Whether you opt for a fixed, variable or adjustable rate mortgage, you will have the choice of whether it’s open or closed. But what does that mean? Let’s take a look below.
What is an Open Mortgage?
An open mortgage offers the borrower supreme levels of flexibility when it comes to making adjustments to their mortgage. Essentially, the borrower can pay off their mortgage early, make lump sum prepayments or switch to another product at any time without incurring penalties. As such, it’s ideal for longer-term mortgages in which you cannot anticipate what financial and lifestyle changes might occur in the future.
Open mortgages aren’t without their disadvantages, however. Since the lender could lose out if a borrower reduces their amortization period, open mortgages generally have higher interest rates than closed mortgages.
What is a Closed Mortgage?
Where open mortgages offer flexibility, closed mortgages are subject to strict rules. Breaking these rules, i.e. paying early, changing mortgages or reducing your amortization period in any way, will incur penalties—known as break fees. Essentially, you’re locked in to the agreement you’ve made with your lender, and will have to pay to break the terms.
While this may seem restrictive, closed mortgages offer lower interest rates than open mortgages. Different lenders offer different terms, with some being more flexible than others. For example, some lenders will allow you to make lump sum prepayments, but only up to a predetermined limit in a given period.
The fee for breaking your mortgage will vary from lender to lender, and depends on whether you have a fixed or variable rate mortgage. Variable rate mortgages are typically subject to the sum of 3 months’ worth of interest payments, while fixed rate mortgages can be the same, or the sum of the IRD (interest rate differential), depending on which is greater.
What is the IRD?
In a nutshell, the IRD is the difference between what you would have paid in interest had you stayed until the end of your agreed term, and the lender’s current posted rate on the funds they lent you. So, if you agreed to pay 4% interest and your lender can only make 2.5% interest now, you will have to pay the difference (1.5%) for the remainder of your agreed term.
The earlier you break your mortgage, the more you will have to pay. In times of falling interest rates, when many borrowers choose to switch to lower interest loans, this can add up to tens of thousands of dollars.
Which is the Best for You?
Choosing between an open or closed mortgage depends entirely on your circumstances—both current and future—and your personal preferences. For example, if you’re looking for a shorter term product it’s unlikely that you’ll need the flexibility of an open mortgage, and you would perhaps be better off enjoying the lower interest rates of a closed mortgage.
On the other hand, if you’re looking for a level of stability over the long term, where you can’t predict your future circumstances so reliably, an open mortgage is perhaps the better choice. For those looking to sell relatively soon, an open mortgage might be the better option when it comes to renewing your mortgage term, as you will avoid potential penalties incurred from a closed mortgage.
Circumstances can change in the blink of an eye—perhaps you will need to relocate for work, downscale due to a pay cut, or find yourself with the funds to pay off your mortgage entirely. Being tied into a mid- to long-term closed fixed mortgage can cost you dearly if you do need to break it.
Bear in mind that millions of Canadians break their mortgage terms each year for one reason or another, so it’s essential that you go into any agreement with your eyes wide open. Do the math and compare a variety of products, and be sure to ask as many questions as possible.