Open vs. Closed Mortgage: What’s The Difference?
When getting a mortgage, there are several considerations beyond getting the lowest possible interest rate. One of the decisions you must make is choosing an open or closed mortgage.
While you may be familiar with these terms, not everyone understands the differences between open and closed mortgages.
In this article, I explain how each type of mortgage works and let you know when to go for a closed mortgage and when an open mortgage may be more suitable.
What Is An Open Mortgage?
An open mortgage is a flexible mortgage that allows you to make additional payments toward the principal amount without incurring penalties. With an open mortgage, you can pay off your mortgage sooner, or even in full, without facing any prepayment charges.
However, with this increased flexibility comes a higher interest rate. The interest rates on open mortgages are higher than those offered for closed mortgages, partly because the lender takes a higher risk by allowing you more freedom to increase payments or pay off the mortgage whenever you want.
What Is a Closed Mortgage?
As its name suggests, a closed mortgage restricts your ability to make extra payments towards the principal without incurring a penalty. But while closed mortgages have less payment flexibility, you benefit from lower interest rates.
You can choose from two main types of closed mortgages – closed fixed-rate and variable-rate mortgages.
In a closed fixed-rate mortgage, you have a fixed interest rate for the entire mortgage term. This offers stability and peace of mind because your monthly payments will remain unchanged regardless of market fluctuations. A closed fixed-rate is a popular choice among homeowners who want to lock in a rate, especially when interest rates are low.
A variable closed mortgage, on the other hand, has an interest rate that fluctuates with the Bank of Canada’s prime rate. Historically, variable rates have been lower than fixed rates, so some homeowners choose this type of mortgage in hopes of potential interest savings.
However, there is a risk with a variable mortgage that your monthly payments could increase if the interest rate increases. This scenario unfolded during the past 18 months as the Bank of Canada raised its policy interest rate ten times between March 2022 and July 2023.
While closed mortgages limit your ability to make additional payments, most lenders offer some flexibility by allowing you to make extra payments, or prepayments, up to a certain percentage per year without incurring penalties.
Some also allow you to increase your regular mortgage payments by a certain percentage without penalty. These extra payments will help you pay your mortgage faster and save on interest. However, you may be penalized if you decide to pay off more than the allowed prepayment amount or refinance your mortgage during the term.
The penalty is usually the greater of three months’ interest or the interest rate differential, which is the difference between your current interest rate and the rate for a new term.
In choosing a closed mortgage, consider your financial situation and whether you expect any significant changes in the near future. If you plan to sell your home or think you have the extra money to pay off your mortgage early, an open mortgage may be a better choice despite having a higher interest rate.
When to Choose an Open Mortgage
If you plan to sell your home soon, an open mortgage might be a better option. With no penalties for a mortgage early payoff, you’re free to sell your property and not worry about any hidden costs from breaking your mortgage contract. Remember, most closed mortgages allow you to pre-pay only a certain percentage of the principal each year.
You may also opt for an open mortgage if you expect a significant life change soon and want to avoid committing to a closed mortgage term.
For example, if you are going through a marital separation when your mortgage matures, you and your spouse may want to renew into an open mortgage until you know how things will unfold.
Another situation where an open mortgage may be your best option is if you plan on moving your mortgage to another lender.
To avoid prepayment penalty charges, opt for an open mortgage term. But don’t take too long to decide, as you are paying more interest on your mortgage as long as it remains open.
When to Choose a Closed Mortgage
A closed mortgage will get you the lowest possible interest rate, which is the primary reason to opt for a closed vs. open mortgage. Closed mortgages are also well-suited for homeowners who don’t plan to sell their house or pay off their mortgage soon for any other reason.
Open vs. Closed Mortgages: Final Thoughts
In summary, a closed mortgage is almost always the best option for borrowers. That’s because most people who take out a mortgage plan to stay in their home for at least a few years and are looking for the lowest possible interest rate.
And most lenders offer some flexibility when making additional payments on a closed mortgage without incurring penalties.
However, if you plan to pay off your full mortgage balance shortly – for any reason – then an open mortgage may be more suitable. Examples include selling your house and not buying another home, paying off your entire mortgage due to a financial windfall, wanting to transfer your mortgage to a different lender, or undergoing a significant life change (marital split, potential job location transfer).
If you still have questions about which mortgage to choose, speak with a mortgage professional, like a mortgage broker or your bank’s mortgage advisor. They have the expertise to advise you on your specific situation.
Are there any drawbacks to having an open mortgage?
Yes, there can be drawbacks to having an open mortgage. While open mortgages provide greater flexibility for prepayments and do not have penalties for paying off the mortgage early, they generally come with higher interest rates than closed mortgages. This can result in increased mortgage costs over time, especially if you are not planning on making significant prepayments or paying off your mortgage early.
What factors should I consider when choosing between open and closed mortgages?
When choosing between open and closed mortgages, it’s essential to consider your financial goals and situation. For instance, if you anticipate receiving a large sum of money or expect significant changes in your financial circumstances, an open mortgage could offer the flexibility to make extra payments or even pay off your mortgage early without penalties.
On the other hand, if you prefer a stable mortgage payment and the assurance of lower interest rates throughout your mortgage term, a closed mortgage might be the better option for you.
It is important to carefully weigh the potential savings from lower interest rates against the flexibility offered by open mortgages.
How do open and closed mortgages impact the flexibility of payments?
The main difference in flexibility between open and closed mortgages lies in prepayment options and penalties. Open mortgages allow you to make unlimited prepayments without incurring any penalties. This can be helpful if you decide to sell your home or come into a lump sum of money, such as an inheritance.
In contrast, closed mortgages have restrictions on prepayments, and making prepayments above the allowed limits can result in penalties.
However, most closed mortgage products offer some flexibility in the form of annual lump sum or monthly prepayment allowances. Before opting for a closed mortgage, review the prepayment terms to understand how flexible the prepayment options are to your financial situation.