Open or Closed Mortgage: Which Is Better?

Mortgages come in two main varieties; open and closed mortgages. An open mortgage can be paid off early without any penalty, while a closed mortgage offers a lower interest rate but cannot be paid off earlier without incurring a penalty. When purchasing a home or refinancing it’s important to consider your situation and selecting the right type of mortgage might save you a lot of money down the road.

What is a Closed Mortgage?

A closed mortgage has a fixed interest rate for the entire term of the mortgage. For example, if you signed up for a 5-year fixed closed mortgage at 2.75%, your rate will not change during the 5-year period. If you select a variable closed rate mortgage, the payments may not stay constant but your discount rate offered will remain the same over the term of the mortgage.

While the interest rate on a closed mortgage can be fixed or variable, you are not able to pay off the mortgage or break the mortgage term without incurring a penalty. The penalty charged by lenders can be fairly large depending on your mortgage term and rate.

What is an Open Mortgage?

An open mortgage is one where prepayment or additional payment can be made at any time during the term. For example, if you won the lottery, you could pay off an open mortgage without incurring any penalties for paying it off before your term was due. Open mortgages can have a fixed or variable rate.

What’s the Difference Between an Open and Closed Mortgage?

The main difference between an open and a close-term mortgage is their associated prepayment penalties. Open mortgages can be paid off at any time without incurring any prepayment costs, therefore, they carry a higher interest rate compared to closed mortgages.

Open mortgages are often selected when someone knows they may have to break the mortgage soon or plan on selling their home and would like to avoid prepayment costs for breaking their mortgage.

A closed mortgage has prepayment penalty costs if the mortgage is broken or paid off before the term is up. Closed mortgages offer lower interest rates and due to the lower rate, their prepayment costs are high for breaking or paying off the mortgage early. But more recently, lenders have provided more prepayment allowances to help borrowers pay off their mortgage quicker without incurring additional costs. For example, most of the big banks will allow you to make lump sump payments annually or increase your monthly payments by a certain percentage each year.

What Type of Terms can you get with an Open or Closed Mortgage?

The type of mortgage terms available for both a closed and open-term mortgage should be similar in theory. However, most open mortgage terms are six months to one year. Due to the fact, that there is no penalty associated with paying an open mortgage before its term, lenders charge a higher interest rate. Therefore, a longer-term open mortgage rate will not be feasible and likely won’t make sense compared to getting a fixed rate mortgage and paying the prepayment penalty.

When it comes to closed mortgages, you can have terms that range from six months to ten-year terms. There is no restriction on the type of term you can get with closed mortgages as the lender is able to charge an additional fee if you wish to break the mortgage sooner.

Whether you select an open or closed-term mortgage, you can have either a fixed or variable rate mortgage.

What are the Advantages and Disadvantages of an Open Mortgage?

• Mortgage can be paid off at any time with no prepayment penalty charge (a small administration fee likely will apply).
• Greater flexibility and ability to put down large lump sump payments towards the mortgage.

While those are some of the advantages of going with an open mortgage, there are still some disadvantages such as they tend to have higher interest rates compared to a closed mortgage. Additionally, the terms available are usually shorter as the rate might not make sense for longer-term mortgages.

What are some Benefits of getting a Closed Mortgage?

• Lower interest rate compared to open mortgage.
• Payments will not change (assuming you selected a fixed rate mortgage)

The biggest disadvantage a closed mortgage term has is the large prepayment penalty if you wish to pay off the mortgage earlier or break it.

How to Reduce the amount of Prepayment Penalty on a Closed Mortgage Term

If you believe you might need to break the mortgage or plan on selling in the future, you may want to consider getting a closed mortgage with a variable rate mortgage term.

When you get a closed variable rate mortgage the interest charged by the lender is capped at three months of interest regardless of when you break it. This means you can benefit from having a lower interest rate compared to a fixed rate mortgage while also capping the amount of penalty you are likely to pay if you decide to break the mortgage in the future.

This strategy does have a drawback though. Since you are getting a variable rate mortgage, your payment can fluctuate based on changes in the interest rate and the prime rate. It’s possible you might end up paying more if the spread between the fixed rate and variable rate is not wide enough.

However, this might still work for you if your primary objective is to cap the amount of penalty you would be exposed to as you know you will be selling or perhaps coming into an inheritance and plan to pay off the mortgage.

Which Should You Pick: Open or Closed?

As for which type of mortgage option is better, it really depends on your situation. There are times when signing up for an open mortgage might make sense, such as if you plan to sell your home in the next few months and want to avoid a large prepayment penalty.

A closed mortgage term likely makes more sense if you have no plan to sell your home or don’t anticipate coming into funds to be able to pay off your home before the term, therefore, securing the lowest rate possible to help you reduce your interest cost makes more sense.

The decision comes down to each person’s unique situation. But the most common type of mortgage often selected is a close mortgage largely due to the lower interest rate they offer.