What you need to know about mortgages, Part 1: open vs. closed

“What’s the best kind of mortgage?” is perhaps the number-one question on homebuyers’ minds, whether it’s your first time or your fifth. Should you opt for a closed fixed mortgage? An open fixed? An open variable with a reduced term? Or just a good ol’ five-year fixed with an espresso shot?

OK, I joke, but talk to an independent mortgage broker about your options and the conversation will soon start to sound as complex as a specialty drink order you make at your local Starbucks.

The real question most buyers want answered is: “What is the best mortgage for me?”

And there’s no one tidy way to reply. The answer really does depend on your specific circumstances, such as:

• your job security;
• current and future mortgage rate predictions;
• the desired payment options;
• the potential payout penalties;
• the amount of flexibility you want;
• and even the potential for rewards.

In an effort to offer a bit of clarity, I thought it might help to define some key terminology you might hear when discussing mortgage options.

COMPARE MORTGAGE RATES: MoneySense Mortgage Rate Finder*

Open mortgages vs. closed mortgages

The vast majority of home buyers will end up choosing a closed mortgage, regardless of whether you favour a fixed or variable rate, most of you will still end up choosing a closed mortgage. Why? Because open mortgages usually come with higher rates.

So, why would anyone opt for an open mortgage? To appreciate the answer, we first need to define what a closed mortgage does (and why, besides rates, it is so popular).

What is a closed mortgage?

A mortgage is a contract between you and a lender. The lender is obligated to forward you loan money and you are obligated to adhere to the terms of the mortgage agreement. These “terms” define what you must do as the borrower and what penalties you can expect if you don’t live up to those obligations.

A closed mortgage, then, is a mortgage contract where the terms are agreed upon at the start of the contract and cannot be changed, altered or cancelled unless you pay a penalty. That’s why it’s called closed: The option to change the terms is gone and the contract negotiation is now closed.

Closed contracts can be for any length of time—from a few months to multiple years. The most common is the five-year closed, which means that for five years the borrower and lender are obligated to adhere to the mortgage contract terms that were agreed upon at the start of the contract. (The length of time a contract is in place is known as a term, with the most common being a five-year term.)

If, during your mortgage term, you need to move and, thus, cannot stay in your closed mortgage agreement, you will be subject to fees and penalties. The calculation of these fees and penalties will depend upon a few key factors, including the length of time until the term ends, the difference between the rate you’re paying versus the posted rate, and whether or not the rate was fixed or variable, but rest assured you will have to pay fees and penalties to cancel your mortgage.

What is an open mortgage?

Open mortgages, on the other hand, allow you to pay just the agreed upon sum at the agreed-upon intervals (such as monthly or bi-weekly), or you can make lump sum installments or pay off the entire loan in its entirety at any time, without penalty.

Open mortgages are ideal for people who anticipate a windfall or want the flexibility of paying off a mortgage as quickly as possible, without incurring penalties.

But those who select open mortgages will have to pay higher rates for the freedom and flexibility offered by this type of mortgage contract.

How to choose between an open and closed mortgage

To help you make the choice between an open and closed mortgage, answer the following questions:

1. Do you plan (or expect) to move/sell your home before the mortgage term ends?
2. Do you expect a large sum of money, such as an inheritance, within a predictable (and short) period of time?
3. Are you carrying a mortgage for a smaller sum because of tax considerations? (But you have the ability to pay off the mortgage should the need arise?)
4. Did you buy the home as an investment with the intent of flipping or selling it within a short period of time?

If you answered yes to any of the above questions, then you might consider an open mortgage. You will probably benefit from the freedom and flexibility it offers to pay off the mortgage debt quickly without incurring penalties.

For just about everybody else, look at closed mortgage options. Why? Because most of us are price-sensitive and this means shopping for a mortgage boils down to getting the best rates first, and then considering other factors.

MORE FROM ASK A REAL ESTATE EXPERT:

• Selling your home to your kids—for $1
• Does it make sense to sell two condos to buy one pricier home?
• Should you buy real estate just to stay in the market?
• Capital gains surprises on the sale of your co-owned cottage