Open vs. Closed Mortgage: Differences Explained

If you are planning to buy a house or a piece of property, a mortgage is a common financing solution. However, with a wrong mortgage plan, you might end up paying more than planned.

Mortgages are a big decision, and there’s a lot to consider before taking one out. These days, there are a lot of different types of mortgages available, so it’s important to understand the differences before you make your choice.

What Is a Closed Mortgage?

Closed mortgages offer predictability and stability, especially if you choose a fixed rate. That locked-in rate will remain in place for the entire life of the loan, giving you peace of mind when it comes to budgeting.

Closed mortgages typically have lower interest rates than open mortgages, which can save borrowers thousands of dollars. 

Let’s say you want to take a mortgage to purchase a home. You sign the contract and start repaying the loan, but you inherit a large sum of money a couple of months later.

Usually, you’d put that money in the mortgage payment, but there would likely be repayment penalties due to the closed loan contract you signed.

However, most closed mortgages allow you to prepay a certain amount each year without penalty. This amount is typically up to 20% of the original loan amount.

Unless you’ve agreed to a variable closed mortgage, you cannot change the amount of your payment or the period you need to pay it without exposing yourself to the fee.

The term for a closed mortgage loan can be anywhere between six months and 10 years.

Interest Rate Differential

When considering a closed-end mortgage, one important factor to keep in mind is the interest rate differential (IRD).

It represents the distinction between the interest rate on your mortgage and the interest rate on comparable security. 

IRD is, in other words, the cost of breaking your mortgage contract early.

If you need to break your mortgage contract before it matures, your lender will charge you the IRD as a closed mortgage prepayment penalty.

It’s best to choose a closed-end mortgage with a low IRD in order to minimize your costs.

To find out the IRD on a particular closed-end mortgage, simply ask your lender or look it up online.

When comparing different mortgages, be sure to compare IRDs in addition to interest rates to get the full picture.

What Is an Open Mortgage?

By definition, an open mortgage rate offers borrowers the flexibility to make additional payments without incurring any penalties.

This can be especially beneficial if you get some extra money or simply want to pay off your mortgage faster. 

Making larger payments can help reduce your overall interest costs and may even allow you to shorten the term of your loan.

Additionally, an open mortgage gives you the option to take a payment break if you experience financial difficulties.

This can provide some much-needed breathing room without putting your home at risk. As such, an open mortgage offers several advantages that may appeal to borrowers in various situations.

You could end up paying more interest overall with an open mortgage because open rates are usually higher than closed rates.

Closed mortgages are more popular as people prefer paying a lower interest rate. 

Still, an open mortgage is a great choice for those whose monthly earnings are not uniform, such as freelancers or those expecting a pay raise in the future.

Suppose you’re 25 years into a 30-year amortization and want to refinance your loan to take advantage of a lower interest rate. In that case, you should be able to do so without penalty, thanks to the open term.

An open mortgage term can be anywhere between six months and five years.

Fixed and Variable Mortgage Interest Rates

There are two main mortgage interest rates, fixed and variable. Both come with their advantages and can be applied equally to closed and open mortgages. 

Fixed Mortgage Interest Rate

A fixed-rate mortgage rate allows absolutely no flexibility in paying off the mortgage. The payment terms are set in stone, and there are penalties for any deviation.

The penalty is typically the interest rate differential or a three-month interest on your current mortgage principal, whichever is greater.

A 5-year fixed closed mortgage is the most common choice in Canada today.

Variable Mortgage Interest Rate

The difference between a fixed and a variable mortgage rate is interest rate fluctuation. A variable-rate mortgage wavers over time as it’s usually tied to one financial index, making it a more risky choice. 

While the mortgage rate stays the same, your interest rate fluctuates depending on the current market. If the interest rate drops, more of your payment will go into paying off the rest of the debt.

However, if the interest rate rises, you’ll end up paying a higher rate.

What To Consider When Taking Out a Mortgage?

Whether you’re looking into an open or a closed mortgage, here’s what else you should consider before making a decision:

• Income
• Expenses
• Risk tolerance

Once you determine these factors, take into consideration the available rates and choose whichever suits you better.