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Open or closed mortgage: Which to choose?

by Corben Grant on 19 Aug 2022

Choosing the right mortgage for you can be a stressful process. Besides just being a long-term contract that will affect you for multiple years, mistakes can be costly too. One area that people are commonly unsure of is the difference between an open and closed mortgage.

This confusion may be due in part to the fact that open mortgages tend to be not as common, and so you may not have realized it was even an option for your home purchase. And, even if you know the difference it can be hard to know exactly when you should use each. Opting for one, when you should have chosen the other can ultimately result in thousands of dollars of overspending, while smartly using the right option can save money.

Luckily the difference between open and closed mortgages is simple enough to explain. The matter of which one is right for you may be a bit harder to address, but we will help make the decisions a bit smoother by offering some ideas to consider.

What is a closed mortgage?

A closed mortgage is simply a mortgage where you are locked into the contract for the set period of your term. When you agree to a term with your lender, you will be required to continue as per the contract until your term has run its course. Because your lender can count on your recurring payments for a set number of years, these loans tend to have lower interest rates than open mortgages.

This can be thought of as the standard mortgage type, as it is the most common type of mortgage that people opt for. Most people plan on paying their mortgage for a number of years anyway, so being locked in is not so much of a downside.

When you sign for a closed mortgage you aren't truly locked in, however, as there is still a way out of the contract, at the cost of high early repayment fees. The cost of these fees can be a primary consideration when looking at getting an open or closed mortgage.

What is an open mortgage?

An open mortgage is the opposite of a closed mortgage, that is to say, you remain within the contract at will and can exit at any time by paying off your mortgage debt in full without penalty. Besides the open contract, these mortgages also differ in a few other ways. For one, they tend to be shorter than closed mortgages, usually from about six months to five years.

In addition to this, the bank needs to make up for the fact that you can leave, and thus stop paying interest at any time. In order to cover this risk to their profits, the banks tend to charge significantly higher interest rates on these mortgages.

In general, open mortgages are not as common in Canada, but the option is commonly offered by most lenders for those borrowers who want the option.

Variable and fixed rate mortgages

In addition to the difference between an open and closed mortgage, there still exists the difference between variable and fixed-rate mortgages. Both open and closed mortgages are available in both variable and fixed rate varieties.

Just as the choice of open vs closed mortgage offers its own pros and cons, so too does the decision between variable and fixed mortgage rates. As a result, there exists a spectrum of mortgage options that offer different levels of stability, flexibility, and value.

On the most stable side, you have a fixed-rate closed mortgage. This mortgage will essentially pay the same amount every month but will be locked into a set time period, as well as locked into a fixed rate.

On the opposite side, you have a variable rate open mortgage. This mortgage can have wildly different mortgage payments throughout its life as interest rates change and as the borrower decides to pay more or less. Luckily, many variable rate open mortgages will provide you with the option to convert to a closed fixed rate mortgage at any time, allowing you to take advantage of the best rate available.

It is also worth noting in this regard that prepayment penalties vary between closed mortgages with fixed and variable rates. In general, a variable rate mortgage will have lower prepayment penalties.

Open Vs Closed mortgages: Which is right for me?

The question then comes down to which mortgage you should choose for your home.

When in doubt, go for closed

In general, most people will be just fine with a closed mortgage. Look at it this way: you probably worked hard to save up a down payment for your home, and that probably took some time. Consider how long it took to save for just that portion of your home, and think about how realistic it would really be to pay off your mortgage early. For most people, the option is not even a consideration – after all, that is the whole point of a mortgage.

Closed mortgages also come with the natural benefit of lower interest, and many people also like the reliability they offer. When you get a closed mortgage, especially with a fixed interest rate, you can generally count on paying the same amount every month without putting much thought into it or feeling pressure to try and save to pay off your mortgage sooner.

When is an open mortgage the right choice?

When should you consider an open mortgage? These will be a more niche scenario, but there are certainly times when you may want to consider it.

For example, if you anticipate yourself getting a very significant increase in income or a windfall amount of money that will allow you to pay off your home much earlier, it may save you some money to choose an open mortgage.

This may also be a good option if you know you plan on refinancing or selling your home soon but aren't ready to do so just yet when your renewal period comes along.

Ultimately, each of these scenarios are not open and shut. You will need to carefully consider the timing of how soon you plan to pay off the mortgage, current rates, and what each option would stand to cost you.

Prepayment penalties vs higher interest rates

Ultimately, if you plan to pay off your mortgage early, you are choosing between two downsides: prepayment penalties on a closed mortgage, or higher interest on an open mortgage.

Prepayment penalties can be quite hefty but will reduce the closer you get to the end of your mortgage term. High interest on the other hand will cost you less the sooner you can pay off your mortgage and exit the mortgage contract. Because of this, there may actually be scenarios where it is more beneficial to go with a closed mortgage, even if you plan on repaying, depending on what the incurred fee will be.

The calculations of different interest rates and prepayment penalties can get quite complex, and the costs of a mistake can be costly. It will certainly be in your interest to consult with a mortgage broker if you are considering an open mortgage, and they can help you to determine if it is a good choice for you.

Conclusion

Most Canadian mortgages these days are on closed mortgagee contracts. This means that the buyers must continue paying for the set period or pay a hefty penalty. However, due to the high prices of homes, this does not bother most people as they don't plan on being able to pay early anyway.

Open mortgages on the other hand are a less popular option, but for those who choose to use it, they are likely thankful the option exists.

If you don't think you are going to be able to pay early or want to refinance, the choice of a closed mortgage is simple. On the other hand, if you think you can pay early, you should still carefully consider both options with a mortgage broker to determine if this option works for you.



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