It doesn’t matter if you’re applying for a new mortgage or renewing your current one, you need to decide if you want to go with a closed or open mortgage. While the vast majority of homeowners go with closed mortgages, there are a few occasions where an open mortgage may make more sense. Depending on your personal situation, it might even be worth thinking about a convertible mortgage. It’s important to know your options so you can make the right mortgage decision for your needs.
What is a closed mortgage?
Whenever you get a mortgage, you’re establishing a contract with terms and conditions. With closed mortgages, once the terms are set, they are closed — you can’t change or break them unless you pay a penalty. The duration of the contract is up to you and can range from six months to 10 years, depending on the options offered by your lender, but most people go for a five-year term.
Even though your mortgage is closed, your original terms will likely allow you some prepayment options. For example, you might be able to prepay up to 20% of the original principal amount of your mortgage once a year. Alternatively, you might be able to double up your regular payments.
However, if you need to move or sell your home, you’d likely be forced to break your mortgage. That’s when you’d be hit with fees and penalties. Essentially, you’ll need to pay to get out of your mortgage contract.
The amount you’ll pay to break your mortgage depends on the calculation used by your lender. It’ll either be the interest you’d pay for the remainder of the term based on a rate called the interest rate differential (IRD), or three months of interest, whichever is higher. While this may seem unfair, it’s a way for lenders to recuperate some of their costs. Most homeowners will go with a closed mortgage because the interest rates are usually significantly lower than those for open mortgages.
What is an open mortgage?
Open mortgages are much more flexible. Not only can you increase your regular payments, but you can also make additional lump-sum payments whenever you want without paying a penalty. However, this freedom comes at a cost, as the interest rates on open mortgages can be significantly higher than those on closed mortgages.
Paying a premium to have an open mortgage may not seem to make financial sense, but there are a few situations where it could save you money in the long run. For example, if you’re expecting a financial windfall or you may need to sell your home before the end of the term, an open mortgage could potentially save you money, since you won’t have to pay a prepayment penalty to break your mortgage. That said, you may need to pay an administration charge to get released from your open mortgage, so check the terms and conditions before you sign.
Pros and cons of a closed mortgage
Many homeowners will naturally gravitate towards a closed mortgage because of the cheaper interest rates. However, you still need to consider the pros and cons.
- Lower mortgage rates compared to open mortgages
- Can come with prepayment and lump-sum payment options
- There’s a limit to how much you can prepay (if you can at all)
- Huge penalties are required if you need to break your mortgage
- Refinancing can be costly
Pros and cons of an open mortgage
There’s no doubt that the flexibility of an open mortgage is a perk, but take a look at the pros and cons before deciding whether it’s for you.
- No penalty when increasing your regular payments
- No charge when you make lump-sum payments
- Refinancing is easy
- Higher mortgage rates compared to closed mortgages
How to choose between open vs. closed mortgages
When deciding between open vs. closed mortgages, ask yourself the following questions:
- Am I expecting an inheritance or large sum of cash in the near future, which I could use to pay off my mortgage?
- Will I likely move or sell the home before my mortgage term ends?
- Is my household income about to increase, which will allow me to increase my mortgage payments?
If you answered yes to any of the questions, an open mortgage could help you avoid high fees when breaking your mortgage.
Alternatively, you could consider a short-term convertible mortgage, which typically offers an interest rate somewhere between those of closed and open mortgages. You’ll make a short-term commitment to the mortgage and extend it as needed until your situation is more settled and you choose a longer-term option.
Most homeowners expect to stay put for the length of their mortgage term, so they’re more than happy to take the lower rates that come with a closed mortgage. Regardless of what mortgage product you go with, you need to make sure you understand the terms and conditions so there are no surprises if your circumstances change and you need to break your mortgage.