Open vs Closed Mortgages

You have options when it comes to mortgages, and that includes whether to opt for an open or closed mortgage. Each one is designed with a specific borrower in mind, which is why you’ll need to determine what your particular needs are before choosing one over the other.

Let’s take a look at each mortgage type in detail to help you decide which one might suit you best. 

What Is A Mortgage?

A mortgage is a type of loan that homebuyers use to finance the purchase of a home. The home itself is used as collateral against the loan. This allows the mortgage lender to repossess the property in the event that the borrower defaults on the loan payments. 

The entire loan amount must be paid back in full by a certain date via installment payments, which include the loan amount plus interest.

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Types Of Mortgages In Canada

One particular aspect to consider when applying for a mortgage is whether to choose an open or closed mortgage. Each has its own advantages and disadvantages, so it’s important to understand what each mortgage type is and assess it based on your specific situation. 

Closed Mortgages  

Closed mortgages typically come with terms ranging from anywhere between 6 months to 10 years. They also usually have lower interest rates than open mortgages. Closed mortgages are generally more popular than open mortgages among homebuyers in Canada because most prefer to have a longer time period within which to pay off their mortgage. They also come with fixed monthly mortgage payments, which makes budgeting much easier.  

Closed Mortgage Prepayment Policies

Closed mortgages have a lot of rules and restrictions, you generally cannot pay off your mortgage in full before your term ends without a penalty. You also can’t renegotiate or refinance the home loan before the end of the term. Paying the mortgage off early will subject you to an early repayment penalty fee, which can cost a few thousand dollars. 

That said, some closed mortgages may come with a prepayment contingency. In this case, you may be allowed to increase your monthly payments by a certain amount or have the opportunity to make one lump sum payment every 12 months if you have the cash to do so. 

Advantages Of A Closed-Term Mortgage

• Interest rates are lower
• A better choice if the borrower wants to pay off their loan faster
• The cost of borrowing will end up being less because of lower interest rates.
• The possibility of pre-payment options that will allow you to pay your mortgage quicker
• Lump sum payments and increasing monthly payment amounts are possible

Disadvantages Of A Closed Term Mortgage

• Mortgage terms cannot be refinanced or renegotiated before the loan reaches maturity without penalty costs
• The terms are longer varying between 6 months to 10 years.
• Because it has lower interest rates, there are more restrictions as to how you can make your payments.
• If there is a possibility to want to refinance your mortgage and break the mortgage loan early you will suffer penalty costs.

Open Mortgages

Open mortgages typically have shorter terms of 5 years or less, though the lender doesn’t have to hold the loan until it matures. Unlike closed mortgages, open mortgages allow borrowers to fully repay the mortgage loan amount, renegotiate the terms, or refinance the loan at any time with no penalties. 

Borrowers may find this option more attractive if they believe they may be able to come up with large sums of money from time to time to put towards the principal portion of their mortgage. By doing so, borrowers may be able to pay off their mortgage early, which not only reduces their overall debt but also saves them money in interest overall. 

The interest rate associated with open mortgages is usually higher than closed mortgages in exchange for greater flexibility. With an open mortgage, you can expect to pay the prime rate plus a certain premium. 

Advantages Of An Open Mortgage

• The borrower has the freedom and flexibility to pay what they want
• The borrower does not need to worry about fines if they decide to pay off their loan earlier or refinance.
• The term is shorter so if the borrower has some financial uncertainties they will have the freedom to reach maturity faster or refinance if they so choose

Main advantage: Payment flexibility

Disadvantages Of An Open Mortgage

• Higher interest rates; the flexibility of the open mortgage allows lenders to propose higher interest rates.
• The cost of borrowing will tend to be higher because of the higher interest rate.

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Mortgage Prepayments: Open Mortgages vs. Closed Mortgages

The biggest difference between open and closed mortgages is the level of flexibility between the two. Namely, closed mortgages are not as flexible because they cannot be paid off early without a prepayment penalty fee involved.

While you might be able to repay your mortgage early on a closed mortgage, you can’t do so without being slapped with a penalty fee for doing so. The exact amount you’ll have to pay to cover prepayment penalties on closed mortgages depends on whether your mortgage rate is fixed or variable.

Fixed-Rate Mortgage

On a fixed-rate mortgage, the prepayment penalty fee can be one of two things, whichever is greater:

• Interest Rate Differential (IRD) – The IRD penalty takes into account the interest your lender would be losing due to you breaking your mortgage contract early. The IRD is calculated by taking the difference between the amount of interest you’d be paying on your current term vs the next term.  However, every lender may have their own way of calculating the IRD, so it’s important that you check your mortgage contract or speak with your lender to find out what this cost will be for you if you break your mortgage early.
• 3 Months Interest – The simpler option of the two is the 3 months interest.  With this, you’d pay 3 months’ worth of interest as a penalty. However, given today’s low-interest rate environment, borrowers with a fixed-rate closed mortgage who choose to pay off their mortgage early will likely pay the IRD rather than 3 months’ interest. 

Variable Rate Mortgage

On a variable-rate mortgage, the prepayment penalty fee is typically 3 months of interest. 

Interest Rates: Open Mortgages vs. Closed Mortgages

As mentioned, you’ll be more likely to have a higher interest rate with an open mortgage than with a closed mortgage. But the exact rate you’re charged will also depend on whether you opted for a variable- or fixed-rate mortgage. 

Interest Rates On Variable-Rate Mortgages 

The rate on a variable-rate mortgage, whether open or closed, fluctuates at various points throughout the mortgage term based on market conditions. This is because variable rates are based on the prime rate. 

• Closed Variable Mortgages – With a closed variable mortgage, you cannot repay the entire mortgage or refinance it before the end of the term without a penalty. However, these mortgages come with lower interest rates than an open mortgage.  
• Open Variable Mortgages – Variable rates on open mortgages are typically higher due to their flexibility. With an open mortgage, you have the freedom to make additional mortgage payments at any time and even fully repay your mortgage early without penalty.

Check out what is an interest-only mortgage.

Interest Rates On Fixed-Rate Mortgages

The rate on a fixed-rate mortgage remains the same throughout the mortgage term, regardless of what’s happening in the market. 

• Closed Fixed-Rate Mortgage – A closed fixed mortgage does not come with the same level of flexibility as an open mortgage, including when it comes to interest rates. The appeal of a closed fixed-rate mortgage is that the rate is usually lower than it is for an open mortgage, but once you’re locked in, you’re stuck with that are for the duration of the mortgage term. This can be a good thing if rates are expected to increase in the near future, but if they happen to dip, you won’t be able to break your mortgage to take advantage of those lower rates unless you agree to pay the prepayment penalty fee. 
• Open Fixed Rate Mortgage – With an open fixed-rate mortgage, the interest rate will be higher because you’ll have the benefit of locking in a rate while having the flexibility to repay your mortgage at any time without repercussion. Fixed-rate open mortgages are meant to be short-term mortgages, with terms that usually last no more than one year.

What Are Convertible Mortgages?

Borrowers who might be uncomfortable choosing between open and closed mortgages may have the opportunity to take out a “convertible” mortgage, which are fixed-rate closed mortgages with a very short term.

With a convertible mortgage, you have the option to make larger prepayments when your mortgage is up for renewal without having to pay any penalties since the term renewal will be a lot sooner than a typical mortgage term.  

You’ll also be free to convert your short-term convertible mortgage — usually about 6 months — into a longer-term mortgage with no penalties. That said, there could be a fee to convert your mortgage into a longer-term one.

You might want to consider a convertible mortgage if you have intentions of selling your home within 6 months or if you come across a large sum of money to be able to put towards your mortgage and pay it off early. 

This option is also more attractive if interest rates are expected to decline within the next few months. In this case, you’ll be free to lock in a lower interest rate when your 6-month mortgage term ends.

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Which Mortgage Is Right For You?

Your decision to choose an open or closed mortgage should be based on your current financial situation, as well as where you see yourself in the foreseeable future. While flexibility might not be too important for some borrowers, it might be a must-have for others. 

Consider An Open Mortgage If:

• You Want To Sell Your Home – You’re likely to sell your home in the near future. If you plan to sell your home soon, an open mortgage will ensure that you avoid any early repayment fees that you would have to pay if you broke your closed mortgage early. 
• An Inheritance Is Expected – If you know you’ll come across a large sum of money, you could put it towards your mortgage principal, which would be possible with an open mortgage. 
• Your Income Is Expected To Increase – If you anticipate a significant raise at work, you might be able to put more towards each mortgage payment.

Consider A Closed Mortgage If:

• You Plan On Settling Down – If you don’t plan to sell your home within the next few years, you don’t need the flexibility to break your mortgage early. In this case, it would make more sense to take out a closed mortgage to take advantage of a lower interest rate.
• No Financial Changes – You’re expecting your financial situation to remain as is. If you don’t expect your income to change or don’t have any inheritance money coming your way, a closed mortgage might be suitable for you.

Bottom Line

There are clear benefits to both open and closed mortgages, but those perks only apply in certain scenarios. Assess your financial situation and where you foresee yourself in the near future before deciding which type of mortgage to apply for.

Note: Loans Canada does not arrange, underwrite or broker mortgages. We are a simple referral service.