Mortgages are divided into two types. The first is a closed mortgage and the second is an open mortgage. Open mortgages give borrowers the option to pay any amount of mortgage at any time without any consequences. Closed mortgages have a prepayment limit, which means that you can pay a predetermined percentage of the mortgage (usually 15-20 percent of the original loan balance) in a calendar year. If you decide to pay more than this certain percentage in one calendar year, there will be a levy. A typical penalty is payment of at least three-month interest on the amount paid (J. Kiff 2009, s. 5-6).
Because closed mortgages are not as flexible as open mortgages, they are less expensive. Closed mortgages block the borrower for the duration of the mortgage. Most commonly closed mortgages contain provisions that govern the sale of real estate. In this situation, a typical penalty is also imposed, which requires the payment of a three-month interest amount. The penalty may be lifted when a new buyer of this property takes out a new mortgage with the same lending institution (D. Gray 2012, s. 141).
Advantages and disadvantages of a closed mortgage
Both open and open mortgages have their advantages and disadvantages, which are worth analyzing before choosing one of these two options. Analyzing closed mortgages, we can distinguish two main advantages and one disadvantage, which for some may be very significant.
- Lower interest rate - The most frequently mentioned and for most borrowers probably the most important advantage is the lower interest rate compared to an open mortgage. Closed mortgage guarantees borrowers that throughout the entire mortgage period, the interest rate will not increase.
- A better choice for long-term mortgages - For people who care about a long-term mortgage and do not foresee a quick debt repayment option, a closed mortgage is a better option than an open mortgage. Rates will be much lower than in an open mortgage, which which allows the borrower to save money.
- Lack of flexibility- Lack of flexibility is the biggest disadvantage of closed mortgages. All changes to the contract are very difficult to implement and require financial expenses from the borrower. If the owner wants to take advantage of the lower interest rate available than before, he must pay for the change in the contract. Also, if the borrower wants to pay off the mortgage early, only repayment is possible in the amount specified in the contract.
It is not possible to determine whether a closed mortgage or an open mortgage is a better option. Due to lower interest rates, a closed mortgage is a more attractive option, especially for homebuyers who are not planning major changes in the near future. Borrowers who, however, consider the option of having to pay off their mortgage quickly (for example, due to the sale of real estate) should consider the option of an open mortgage. This may allow them to avoid paying high fines.
- Agarwal S., Driscoll J., Laibson D. (2007) Optimal Mortgage Refinancing: A Closed Form Solution "NBER Working Paper Series", No. 13487
- Gray D. (2012) Making Money in Real Estate: The Essential Canadian Guide to Investing in Residential Property, John Wiley & Sons Canada, Ltd., s. 141
- Kiff J. (2009), Canadian Residential Mortgage Markets: Boring But Effective "IMF Working Paper", WP/09/130, s. 5-6
- Vermond K. (2010) Earn, Spend, Save: The savvy guide to richer, smarter, debt-free life, John Wiley & Sons Canada, Ltd.
Author: Agnieszka Damian