Buying a house can be one of the most exciting things you can do in your life, especially when it's your first one. Finding a home that meets your needs and suits your style is a fun adventure that should be enjoyed.
On the other hand, doing your homework on how a mortgage works and trying to understand the variety of options available to you is a whole different challenge. Fixed rate vs. variable rate, open mortgage vs. closed mortgage, amortization period… it can all feel a little overwhelming at times – especially as a first-time homebuyer.
As it is with any big decision, it's important to do your research in order to make an informed decision. This article is going to explore open vs. closed mortgages. What are open and closed mortgages? What is the difference? What are the pros and cons of each? How do you decide which mortgage is best for you?
Let's explore these questions and lower the confusion around these two types of mortgages.
Open mortgages are set up in a way where you can make additional payments to your mortgage at any point during the mortgage term without being penalized. This can be a huge advantage if you are suddenly in a position to pay down your mortgage quicker than what you amortized your mortgage for.
Suppose you land a big promotion in your job and end up making an extra $20,000 per year. With an open mortgage, you can apply this extra $20,000 per year to your mortgage and no penalties will be incurred. This extra payment also goes straight toward the principal amount owing.
A different scenario might be a little less celebratory. Perhaps you find yourself suddenly receiving an inheritance as a result of a loss in your family. Despite this loss, you now have extra cash in hand and this can be used to pay down your mortgage. The entire extra payment can be directed at the principal amount owning and again, no penalties will be incurred because your mortgage is open.
With these advantages, open mortgages also come at a cost. Interest rates on open mortgages are typically 1-2% higher than closed mortgages. This can obviously be worthwhile if you are confident you will be able to make those extra payments, but you can also end up paying a lot more interest than you would in a closed mortgage if you can't make those extra payments.
Simply put, closed mortgages are the opposite of open mortgages. Closed mortgages tighten up the restrictions when it comes to paying off your mortgage by means of making large lump sum payments.
To be fair, closed mortgages do allow for some accelerated amortization, but only up to a certain percentage of the borrowed amount. If you go beyond this limit, you are penalized and you end up working against your own efforts to accelerate paying off your mortgage.
The idea in mind with a closed mortgage is to maintain a stable, fixed rate that is manageable for the borrower. This is an advantage if you are on a tight budget and if you don't anticipate any excessive cash coming your way. The other benefit is a lower interest rate which helps with keeping those payments affordable.
Choosing Between Open and Closed Mortgages
For most people, it's safe to say that closed mortgages are a better option, especially if you are early in your home ownership career. When you are younger, it's less likely that a large amount of extra money will come your way. You will hopefully be in a secure job if you're signing mortgage documents, but it might take a few years before you land that big promotion with impressive salary benefits.
The lower interest rates that come with closed mortgages are notable. A 1-2% difference in interest rate might not sound like a lot, but depending on the amount you are borrowing and the length of your term, this can amount to thousands of dollars in interest savings.
Despite the title, closed mortgages do still allow for some flexibility when it comes to making extra payments. In the event that you do land that promotion at work or if you sell off some other assets that you don't need anymore, there's likely room for additional payments to be made without incurring a huge penalty.
That said, perhaps you are considering a big move across the country in the near future. Or perhaps you are in the stage of life where you might see some inheritance money come your way. These can be reasons to consider an open mortgage where you won't be penalized for making large lump sum payments or paying off your mortgage altogether.
Which One Is Best For You?
Decisions like these aren't always easy, but the important thing is to do your homework. Crunch the numbers and assess where you are at. Pay attention to the season of life you are in and try to anticipate any foreseeable financial changes you might encounter.
The banks or your mortgage broker can guide you through the best choice.
In the end, stay relaxed and enjoy the process. Determine a path that works for you and one that allows you to sleep at night. And then enjoy this place you get to call home!