Click on any mortgage lender’s website and there’s a good chance you’ll see four terms when outlining their mortgage products: fixed, variable, open, and closed.
Open and closed mortgages can be used with a variety of mortgage options and terms. Regardless of whatever other options you can choose for your mortgage, however, there are two differences between open and closed mortgages: there’s a difference in interest rates, which means more (or less) money in your pocket; and there’s a difference when it comes to how much you can pay toward your mortgage balance and when you can pay it. As with all mortgage products, choosing what’s best for you depends on your expected needs during the length of the mortgage term.
Simply speaking, closed mortgages have restrictions when it comes to being paid off or renegotiated before the specified loan term is complete. Some closed mortgages cannot be paid off before the term ends without paying a large penalty, and other closed mortgages have a prepayment limit, with the borrower incurring severe penalties if any payment over that limit is made. The door is closed on these mortgages, so to speak; once you sign on the dotted line, the lender considers it a done deal and it’s hard to make any changes.
Open mortgages are flexible in that you can make lump sum prepayments or accelerated payments without penalty in order to pay the loan before the end of the amortization period. Although open mortgages have greater flexibility, they tend to have slightly higher interest rates than that of a closed mortgage. With these, the door is essentially open when it comes to making changes.
Lenders offer lower interest rates for closed mortgages because they can make more money off of them than with open mortgages. With open mortgages, you can pay off your mortgage sooner, which means less money paid in interest to the banks over time. Not to mention that lenders make money off of the penalties that borrowers pay when they end up breaking their mortgages, which hundreds of thousands of Canadians do each year.
Which one should you choose?
When looking at mortgage products, you want to choose the one that best fits not only your current financial situation, but also what you expect your financial situation to be in the near future. If you want a mortgage with a shorter term, say, one or two years, then you probably won’t have as much need for the flexibility of an open mortgage. Barring any unexpected trauma or disaster, people generally know about any circumstances on the horizon that may dramatically alter their financial situation, such as a big promotion or plans to take a sabbatical. On the flip side, if you know that you want a 10-year mortgage term and the stability of consistent payments for that period of time, you can’t expect to know how your financial picture will look in a decade. In that case, then you’ll want as much flexibility as you can get, which includes the option to make prepayments if you’re able to do so during that time.
You should know, however, that flexibility comes – quite literally – at a cost. Closed mortgages generally offer the lowest interest rates, in addition to having a set monthly payment plan. There are lenders who can offer closed mortgages that have limited pre-payment options without any additional fees or penalties, however, so shop around or let your mortgage broker know if this is important to you. If you choose a completely closed mortgage without any flexibility in pre-payment options, then the only way out of the mortgage penalty-free before your term ends is to sell the property.
The benefits you get with the higher interest rate of an open mortgage, however, may outweigh the financial benefits of the lower interest rate. Geoff Lee is the president and senior mortgage director of the Vancouver-based GLM Mortgage Group, and when clients come to him asking about lenders’ advertised rates for closed mortgages, he prompts them to dig deeper. “These rates are ridiculously low, but what is the personality within that rate? . . . Can you tell me about the prepayment privileges? Can you tell me what the penalty is to break?” Often times, he says, clients say no. “Seven out of 10 Canadians will break their mortgage within five years . . . the difference between something that might be restricted and cost you $12,000 to get out of versus say, something that’s only $1,200 to get out of might only be $8 a month. A lot of times, people misunderstand.”
But how bad are those penalties?
If you break your mortgage – and yes, refinancing while in the middle of your term to get a lower interest rate is considered breaking your mortgage, even if you stay with the same lender – then you’ll have to pay a penalty. This penalty can range from three months’ worth of interest on the low end to a calculation called the interest rate differential (IRD), which is often a much higher amount. The IRD can be a complicated calculation and differs from lender to lender, but in essence it simply calculates the differential between what you were going to pay if you continued with your current mortgage versus what the lender can resell that money for in the current market.
For example, if you have three years left on your current five-year mortgage at 4.79% and you find a better deal with a different lender, your current bank will take the balance of the money owing, determine what rate they can sell that for in today’s market (for example, a three-year term at 2.4%) and then calculate your mortgage break penalty based on the potential lost revenue. You can use a mortgage penalty calculator to determine the exact amount it will cost to switch mortgage providers, but be sure to ask your lender and/or mortgage broker to go through each scenario with you. When interest rates are low, then the three months’ interest penalty is relatively inexpensive, and if you have a large mortgage with a lot of time left, the IRD penalty can be significant. But if you’re refinancing to a much lower interest rate, you may save money in the long run even with paying the penalty – again, depending on the amount of that penalty.
“The one thing that I try and help buyers understand more and more is pre-payment penalties, and understanding why they’re important,” says Sheri Creese, a mortgage broker with Mortgage Brokers Ottawa. “No one ever thinks they’re going to break their mortgage but most people do. . . . no one ever moves on their maturity date. Even if you’re six months before your maturity date the next time you move up, you’re probably going to lock in for another five years, and you’re going to pay a penalty to do that.”
Knowing your options before you have to exercise them is key for home buyers when debating between an open and a closed mortgage, as well as understanding how specific terms and small print will affect your bottom line. “Even if it feels like it doesn’t apply to you, it will,” Creese says.
Read more about fixed vs. variable rate mortgages, and consult your mortgage broker to discuss whether a fixed rate mortgage right be right for you.