OPEN VERSUS CLOSED MORTGAGES
The default choice is a closed mortgage.
Most people understand the difference between fixed and variable rate mortgages, and even have an idea of which one they are more comfortable with. A less commonly discussion option when it comes to mortgages is the open versus closed mortgages term. This is likely because most mortgages are closed term. They’re the default choice, and with good reason as they tend to fit most homebuyers’ needs very well. There are some circumstances, however, where an open term mortgage might be what you need, so it’s helpful to understand what sets them apart.
The basic difference between an open and a closed term mortgage is one of flexibility. A closed term, which can have a fixed or variable rate, is set for a number of years, and the lender does not permit the entire amount to be paid back unless you also pay a penalty. Typically there are allowable pre-payment amounts, but beyond that you’ll be charged the greater of an interest rate differential penalty or three months interest on the balance. The reason for a lender charging pre-payment penalties on these kinds of mortgages is that that when they lend you the money, they are counting on a particular return on their investment over the length of the term in the form of the interest you’re paying. In exchange for you locking in for those years, they give you a lower interest rate. They get the guarantee of a certain amount of interest, and you get a lower monthly payment.
With an open term mortgage, on the other hand, there are no restrictions when it comes to paying the money back. These are typically for shorter terms (1 or 2 years) and are set at significantly higher interest rates. The benefit to the lender is a better return, however they don’t know how long you will continue paying that interest before re-paying the mortgage in full.
Open terms are often used when someone is unsure of what his or her next housing move will be. For example, your mortgage may come up for renewal, but you’re considering selling your home. You wouldn’t want to renew into another 5 year term if you’re only going to sell in the next 6 months (as this would result in a penalty when the mortgage was paid out from the sale). So, you might look at a 1 year open term so that you could list your house and look for another one without costing yourself too much extra in the event you did sell. You’re paying some extra interest in the short term, but avoiding a potentially large penalty down the road. If you’re especially unsure, some lenders also offer open terms that are convertible into closed terms down the road.
Open term mortgages tend to be shorter term solutions than your standard closed term mortgages, however they can be enormously helpful under the right circumstances. Your mortgage broker can help you figure out if an open or a closed term mortgage is the better choice for you, so give us a call to talk options and figure out what solution will meet your needs.