To start, it’s useful to define an open and closed mortgage. A closed mortgage is one that cannot be fully paid off or refinanced before the end of the term without a penalty fee being charged. An open mortgage, on the other hand, has no such repayment restrictions. Borrowers of an open mortgage can pay off or refinance their mortgage at any point during the term without incurring penalties.
Typically, open mortgages are repaid over a shorter time period, but offer high variable interest rates. Closed mortgages on the other hand tend to have lower rates and are repaid over a longer term.
The Advantages of Closed Mortgages
The primary advantage of the closed mortgage lies in the fact that it offers lower rates than the open mortgage. Over the course of a 25 to 30-year loan, this can result in thousands, and possibly tens of thousands of dollars in savings. Closed mortgages also offer a fixed repayment schedule, which provides consistency and saves you from having to decide on whether to prepay more of your outstanding mortgage balance or not.
The Disadvantages of Closed Mortgages
- If a lump sum prepayment is to be made, the penalties for doing so can be hefty.
- Refinancing a closed mortgage may be expensive and challenging.
- Even if you sell your home, you might be in for hefty prepayment terms unless you port your mortgage over to your new home, provided that your mortgage terms allow for this option.
The Advantages of Open Mortgages
- In an open mortgage, borrowers can increase their scheduled payments without paying any penalties. This allows them to pay down the loan balance faster, thereby potentially saving them interest costs over the life of the loan.
- A lump-sum payment on the mortgage can be made at any time with no penalty incurred.
- In an open mortgage, refinancing the mortgage can be significantly cheaper and more flexible as compared to a closed mortgage.
The Disadvantages of Open Mortgages
The main disadvantage of an open mortgage is the fact that it is usually accompanied by higher interest rates on the mortgage than the interest rate on a closed mortgage. This is done by lenders to compensate for the loss of expected interest income in the event that the borrower prepays the mortgage loan substantially earlier than planned.
Which mortgage is right for you?
For most borrowers, a closed mortgage is the preferred option. The flexibility provided by an open mortgage is generally not a matter of consideration for most individuals. Instead, most borrowers value a lower rate, which can save them interest costs over the life of the loan. However, there are certainly some cases in which the open mortgage does make financial sense. These include:
(i) The borrower plans to sell the home soon: If the intent is to sell the home and pay off the mortgage in full from the sale proceeds, then an open mortgage is the better option as it will allow the borrower to do so without incurring penalties. In addition, the lower interest rate offered by a closed mortgage is also no longer a consideration here as the home is being sold off in the very near future.
(ii) The borrower is expecting a large windfall of money: If the borrower expects to come into some additional money soon (such as an inheritance for example), then an open mortgage enables them to pay off the mortgage partially or in full quickly with no penalties.
(iii) The borrower expects a large increase in his/her income: Similar to the situation above, if the expectation is that there will be additional funds at the borrower’s disposal soon, then an open mortgage can allow the borrower to increase monthly repayments without incurring additional penalties.
Ultimately, the choice between an open and a closed mortgage is up to the individual borrower and contingent upon his/her financial profile and priorities. If the expectation is that their income and capital is going to stay the same or show stable incremental growth over a period of time, then a closed mortgage is probably the better option as it provides a lower rate, and therefore cost savings on interest payments. On the other hand, if the borrower expects their income or capital to rise quickly and/or if they are planning to sell off their home rather than live in it long-term, then an open mortgage can allow them to prepay the mortgage partly or in full without worrying about paying additional penalties or fees.
It is therefore in your best interest to explain your situation to a trusted mortgage broker or financial expert and discuss potential options before committing to one type of mortgage.