Mortgage types: Open vs Closed

Most lenders offer two types of mortgages: Open and Closed.

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.

Closed Mortgage

A closed mortgage means that you are agreeing to a term. Terms can range from 6 months to 10 years. If you back out of the mortgage before the term is up, you will have to pay a penalty. The penalty is usually three months of interest, or the Interest Rate Differential (IRD) depending on which one is HIGHER (but variable rate mortgages don’t have the IRD).

Also, let’s say you received an inheritance of $500 000 and your outstanding mortgage is $450 00. You can’t just pay off the loan just because you have the cash. You will have to pay a penalty to do this.

Your mortgage contract will usually include prepayment privileges, which vary from lender to lender. For example, one lender might let you make a lump sum payment equal to 20% of the original mortgage loan every year, while another might only let you pay down 10% every year. A lender might also allow you to increase the amount of your regular payments.

If you want to change your mortgage agreement during the term (for example, to take advantage of lower interest rates), you will usually have to pay a prepayment charge to break your mortgage agreement.

A closed mortgage may be a good choice if:

the prepayment privileges provide enough flexibility for the prepayments you expect to make
you are not planning to selling your cottage any time soon.
The interest rate on a closed mortgage is usually lower than on an open mortgage as the financial institution knows that you will be paying interest for a fixed period.

Open Mortgage

Open mortgages allow you to make prepayments whenever you want. You can make prepayments at any time during the term, or even pay the mortgage off completely before the end of the term, without having to pay a prepayment charge.

You could buy a cottage in May and sell it in October if you wanted, and not have to pay a penalty for breaking the term.

By making prepayments, you can save thousands of dollars in interest charges by paying down your mortgage faster.

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.

The interest rate on an open mortgage is usually higher than on a closed mortgage with a comparable term length.

An open mortgage may be a good choice if:

you plan to sell your home soon
you intend to make large prepayments that would be more than the amount you would be allowed to prepay with a closed mortgage term.
You believe you are going to win the Lotto or if you may be inheriting some cash soon