Understanding the Difference Could Save You Thousands
The main difference between "open" and "closed" mortgages is the amount of flexibility you have in making extra payments on the principal or in paying off the mortgage completely. These types of extra payments are called prepayments.
By making prepayments, you can save thousands of dollars in interest charges by paying down your mortgage faster.
An open mortgage allows you to pay off your mortgage in part or in full at any time without any penalties. You may also choose, at any time, to renegotiate the mortgage. This option provides more flexibility but comes with a higher interest rate. An open mortgage can be a good choice if you plan to sell your home in the near future or to make large additional payments.
A closed mortgage usually carries a lower interest rate but doesn’t offer the flexibility of an open mortgage. However, most lenders allow homeowners to make additional payments of a determined maximum amount without penalty. Typically, most people will select a closed mortgage.
Kathy has a mortgage renewal coming up in January on one of her rental properties that she wants to sell sometime during the year, but she is not quite sure how long it will take to sell.
She is considering the following renewal options:
*If you are unclear about payout penalties, you can learn more here.
She considers that the open mortgage in option 2 will cost her 4% more per year in interest expense or 0.33% per month. On her $200,000 balance owing, this means an extra $667/mo in interest expense for the privilege of repaying at an time without penalty. Next she calculates the potential 3-months interest payout penalty for options 1 & 3, which comes to $1625 (.0325/12 x $200K x 3). She concludes that if it takes her longer than 2.4 months to sell ($1625/667), it becomes cheaper to pay a break fee on a closed mortgage than take the higher open rate and pay the higher interest.
The final part of her analysis is comparing the fixed vs floating rate options and the potential break penalties. While the rates are currently the same, the variable rate in Option 3 could change her payment while the fixed in Option 1 is constant. But with the fixed option, she needs to take a closer look at the penalty calculation, because it could be higher than the 3 month interest only penalty for Option 3 depending on how the lender does their penalty calculation. She also realizes that if she did not sell as planned, that she would need to renew the mortgage again. Or if she could time the sale to coincide with the maturity date exactly (very hard to do) she could avoid a penalty altogether! After some thought, she concludes that the variable rate (Option 3) is most flexible for her situation.
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However, if you have a closed mortgage and want to make a prepayment that is more than your privileges allow, your lender will generally require you to pay a prepayment charge. These charges can cost thousands of dollars, so it is important to know when they can apply and how they are calculated.
For terms longer than five years: if you want to break your mortgage and at least five years have passed, your lender is only allowed to charge three months’ interest on the remaining mortgage balance. This may be less costly than other methods of calculating a prepayment charge.
When you shop around for a mortgage, look carefully at the prepayment privileges and charges as you consider your options.
Not sure which one you need? Ask your mortgage planner for some advice.
Richards Mortgage Group
73 Riverview Circle
Cochrane, AB T4C1K3
T: 587.774.6290
TF: 1.888.540.1715
Fax: 587.315.6117
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