Open vs Closed Mortgage – What’s the no Brainer Option Now?

WRITTEN BY Dylan Callaghan | UPDATED ON: May 29, 2024

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When considering applying for a mortgage in Canada, you generally need to choose between an open mortgage and a closed mortgage. The primary distinction between these two types usually revolves around their flexibility regarding repayments and the related interest rates.

In this article, we'll discuss the intricacies of both mortgages so that you can choose the one that best suits your financial situation, risk tolerance, and end goals.

Open vs closed mortgage - What's the difference?

An open mortgage allows for the potential to pay off the loan before the end of its term without incurring penalties. In contrast, a closed mortgage typically secures a lower interest rate but comes with restrictions on paying off the loan early.

An open mortgage allows for flexibility in repayment. Although you still make your regular payments, borrowers can pay off their mortgage, in full or in part, at any time without penalties.

This payment structure is advantageous for homeowners who anticipate making lump-sum payments. However, this flexibility typically comes with higher interest rates.

Closed mortgages usually offer lower interest rates than open mortgages, allowing homeowners to benefit from cost savings over time. Nonetheless, they restrict the amount homeowners can prepay toward their mortgage. Penalties are applied for payments above the agreed-upon prepayment limit.

Let's dig further into open mortgages

Open mortgages in Canada offer a flexible repayment structure that is advantageous for borrowers who anticipate making large, lump-sum payments before the end of their mortgage term. 

This type of mortgage does not impose hefty penalties for prepaying large portions or the entirety of the mortgage.

The main benefits of an open mortgage

Prepayment Flexibility: One of the primary benefits of an open mortgage is the ability to prepay any amount of the mortgage at any time without incurring penalties. 

Homeowners who experience a financial windfall, such as from an inheritance, can take advantage of this feature to reduce their debt more quickly.

No Prepayment Penalties: With an open mortgage, borrowers have the freedom to make lump sum payments, amplify their regular repayment amounts, or pay off the entire mortgage without facing a penalty. 

This can lead to substantial interest savings over the mortgage term.

The main drawbacks of an open mortgage

Higher Interest Rate: While open mortgages provide significant flexibility, they typically have a much higher interest rate than closed mortgages. 

This means that over time, the cost of borrowing may be greater unless the borrower capitalizes on the opportunity to make prepayments. If you don't plan to make prepayments or maybe even sell your home in the very near future, open mortgages don't make much sense.

Shorter Terms, Higher Costs: Generally, open mortgages are offered for shorter terms and may come with higher fees. Borrowers must balance the likelihood of utilizing the prepayment options against the additional costs incurred from a higher rate to determine if an open mortgage is the most cost-effective approach for their financial situation.

Let's dig further into closed mortgages

Closed mortgages feature specific contractual terms that cater to homeowners seeking stability in their mortgage payments and a lower rate of interest.

The main advantages of a closed mortgage

Closed mortgages come with lower interest rates than their open counterparts, making them a more cost-effective option for many borrowers over the long term. 

This is because lenders have a guaranteed interest income over the duration of the mortgage term, providing them with more financial predictability.

While closed mortgages have restrictions, they often allow for certain prepayment privileges. This lets borrowers pay off a part of their mortgage, typically around 10-20% of the principal per year, without incurring a penalty.

Don't make any assumptions, however, as every mortgage is different. Check your current terms to see what you could pay off.

For those opting for a fixed-rate mortgage, the interest rate stays constant throughout the term, which can also grant peace of mind in fluctuating market conditions.

The drawbacks of a closed mortgage

Closed mortgages have certain limitations that must be considered. They include prepayment charges, which can be substantial if the borrower opts to repay the mortgage in full before the end of the term.

These are typically calculated based on the interest rate differential (IRD) or three months' interest, depending on which is higher.

In addition, closed mortgages limit the extra money borrowers can pay on their mortgage each year. Paying beyond these limits can result in penalties.

If they break their variable-rate mortgage, they may face a penalty amounting to three months' interest, as opposed to the generally higher IRD that applies to fixed-rate mortgages. In my history of purchasing homes, the buyout penalty on a fixed-rate mortgage is almost always more than a variable.

It's important for borrowers to review their prepayment options carefully and understand the specific restrictions and potential penalties associated with a closed mortgage before making a commitment.

Which mortgage is ultimately right for you?

The choice between an open mortgage and a closed mortgage mainly depends on one's personal financial situation.

For someone who anticipates future liquidity or large cash inflows, an open mortgage allows for flexibility to repay the loan at any time without incurring a penalty. 

This could be beneficial for those expecting a financial windfall or who have fluctuating income and wish to make large lump-sum payments. However, open mortgages typically come with much higher mortgage rates.

When I renewed my mortgage in 2019, I looked at open mortgages very briefly. The rate was more than double a 3-year fixed.

On the other hand, a closed mortgage might be preferable for individuals with a stable income that fits a disciplined budgeting plan. Closed mortgages usually offer lower interest rates, leading to interest savings over time. 

But remember, opting for a closed mortgage means committing to a set of rules for repayment, and breaking these rules can result in significant penalties.

Is it a good idea to get an open mortgage?

An open mortgage in Canada provides a flexible financing option for homeowners. They have the liberty to pay off their mortgage at any time without incurring penalties. This flexibility could be particularly beneficial for individuals expecting a lump sum of cash or those who anticipate moving in the short term.

On the downside, open mortgages typically have higher interest rates than closed mortgages. The higher cost compensates lenders for the increased flexibility offered to borrowers.

It all boils down to what your own needs are.

Can you get out of a closed mortgage?

Exiting a closed mortgage before the end of its term is relatively simple. However, it often involves certain penalties or fees. 

Canadian homeowners may have several options if they need to get out of their closed mortgage.

wdt_ID Option Description
1 Prepayment Penalty Calculated as the greater of three months' interest or the IRD.
2 Porting Your Mortgage If moving to a new home, you might be able to transfer the mortgage to the new property.
3 Assuming the mortgage A buyer may take over your mortgage terms, subject to lender approval.
4 Sale and Break Penalties Selling the property would require paying off the mortgage, including any penalties.

The prepayment penalty is typically three months' interest or the IRD. If you're looking to refinance your mortgage, you may need to pay this penalty during the refinancing process, as you will likely need to pay off the mortgage balance with your new mortgage.

In particular cases, lenders will be generous to mortgage holders in the event of a refinance, especially if you're keeping the mortgage with that lender. However, this is far from guaranteed, and although home buyers should inquire about it, I wouldn't expect anything to be given.

In certain cases, the mortgage can be ported or transferred to a new property if the mortgage terms allow for it and the borrower is purchasing a new home. This allows the homeowner to avoid some penalties by maintaining their current mortgage contract.

This is not available in all mortgages, however. I have had mortgages that were non-portable in the past.

This one is a bit of a stretch, but if a homeowner is selling their property, they can ask the buyer to assume the mortgage. This would mean the new buyer takes on the existing mortgage terms, subject to the lender's approval.

Finally, if the homeowner decides to sell their property, they can get out of the mortgage but will pay the associated fees and penalties.