When choosing a mortgage, it’s important to consider whether you want a closed term mortgage or an open term mortgage. The debate between a closed vs open term mortgage is one that’s worth spending some time on. Understanding the difference between them will help you make a smarter mortgage choice, so here we go.
What is a closed term mortgage?
A closed term mortgage means that your ability to make extra lump sum prepayments towards your mortgage and increase your mortgage payments are limited. If you pay off your mortgage before the term ends, you’ll be faced with a penalty fee.
What is an open term mortgage?
An open term mortgage means that you can make lump-sum contributions towards your mortgage principal without limits. You are free to pay off your mortgage in full, at any time, without facing any penalty charge.
When should I choose a closed mortgage?
If you want a lower interest rate on your mortgage, a closed term mortgage is likely your best choice.
Closed term mortgages offer lower interest rates than their open term counterparts because they giving you, the borrower, fewer options to make extra prepayments towards your mortgage loan.
A closed term mortgage could also be right for you if you don’t anticipate selling your home before the end of the mortgage term or if you don’t expect to receive a large cash amount that you’d want to put towards your mortgage (i.e., receiving an inheritance).
What are mortgage prepayments?
A mortgage prepayment is an extra payment towards your mortgage principal. It also includes increasing your mortgage payment so you can pay it off quicker. In essence, a prepayment is an action you take to reduce your mortgage balance faster than what’s outlined in your amortization schedule.
Can I make prepayments in a closed term mortgage?
Despite being restrictive in their ability to make extra payments towards your mortgage principal, most closed term mortgages do offer some flexibility to make prepayments. Many mortgage lenders will allow you to make an annual lump sum prepayment and allow you to increase your mortgage payment within specified limits.
For example, a mortgage lender may allow you to make a lump-sum prepayment of 20% per year, towards your mortgage principal. And allow you to increase your mortgage payments by 20% once per year as well.
To illustrate this, let’s assume your outstanding mortgage principal amount is $300,000, and you make monthly mortgage payments of $1,700. Let’s assume your lender allows you to make a 20% lump sum prepayment and a 20% increase in your mortgage payment once per year. Under this scenario, you’d be able to make an extra lump sum prepayment of up to $60,000 ($300,000 x 0.2) towards your mortgage principal and increase your monthly payment to $2,040 ($1,700 x 1.2).
For closed mortgages, what happens if I repay my mortgage in full before the end of the term?
If you repay your closed rate mortgage in full before the end of the term, you’ll be faced with paying a penalty fee imposed by your lender.
The penalty fee ranges from lender to lender. But typically, it’s the greater of three months’ worth of interest or the interest rate differential (IRD).
The interest rate differential is the difference in the interest rate when you first got your closed term mortgage and what your lender would get for it today. The more months you have left on your mortgage term, the higher the IRD charge will be.
When should I choose an open mortgage?
Open mortgages come with greater flexibility to pay off your mortgage or make significant lump sum prepayments towards your mortgage principal during the term.
With the greater prepayment flexibility, an open mortgage does come with a significant caveat. Open mortgages have higher interest rates than closed mortgages. You’ll be paying more in interest costs during your mortgage term.
It only makes sense to have an open mortgage, and pay the higher interest costs, if you plan on selling your home or making a large lump sum payment towards your mortgage balance before the end of the term.
You should also note that open mortgages typically have shorter term lengths than closed mortgages. They usually come in 6 month or 1 year terms for fixed rates. For variable rates, open term mortgages typically come in 3 year or 5 year lengths.
How do I choose between a closed term and an open term mortgage?
Choosing between a closed vs open mortgage is a significant consideration to make when shopping around for a mortgage.
Consider if you’d be looking to sell your home during the mortgage term. You’d also want to forecast if you would be expecting a large cash influx that you can use to pay down your mortgage balance or if you expect to receive a significant pay raise over the mortgage term.
What you ultimately decide to choose depends on your financial needs and goals. Take time to examine your financial future and what you aim to achieve over the next few years before choosing the mortgage type that’s right for you.