Knowing the best loan for your needs is not always easy, but the first thing you need to have clear in your mind is the difference between Open vs Closed Mortgages. There are many exciting aspects to purchasing a new home. Poring over floor plans, choosing flooring, looking at swatches of wallpaper or wall paint, picking out light fixtures and making all of those other touches are all steps that go toward building a home. However, choosing the right mortgage can often be an intimidating process, particularly if you have never purchased a house before. In general terms, an open mortgage is eligible for repayment at any time before maturity without any penalty for repayment. Most of these loans have terms that are shorter than a year. For people who are about to see their earnings shoot up or are waiting for another property to sell so that they can pay this loan out in cash, this can be a terrific solution. A closed mortgage brings a penalty if you pay the loan out, refinance or renegotiate before maturity. The terms range from half a year to ten years. The purpose of this article is to give you an overview of both types of mortgages, to help you make the right choice for your own needs.
Open vs Closed Mortgages in Canada
The first question you should ask yourself when making this choice is whether or not you plan to pay the mortgage off within a year. If the answer is No, then a closed mortgage is probably your best bet. Your interest rate is likely to be lower with a closed mortgage, but you certainly want to hash that out with the lender. If you want a closed mortgage that is less than five years in term, the lender may require that you qualify at a higher rate of interest known as the “qualifying rate.” Let’s say that you are applying for a 2.5 percent, five year variable closed mortgage. The lender is likely to require you to qualify at the five-year rate, which could be 5.5 percent (for example). The purpose of running this type of application is to make sure that you can make your payments if the rate on your closed mortgage goes up. So the qualifying process will look at that rate, even though your payments will be calculated at the benchmark rate that you are quoted. If the loan to value (LTV) ratio is 80 percent or less, some lenders will permit you to use lower qualifying rates, but that varies by bank. But what happens if you choose a closed mortgage and then win the lottery a year later?
The prepayment penalty is usually the greater of a three month payment of interest or the Interest Rate differential. This differential is the gap between the mortgage rate on the contract and the current rate that the lender would be able to get for that money. If you have a closed mortgage with a four year term remaining at 5 percent, but the market rate is only 4 percent, you have to pay that interest. Some lenders will waive this if you take out another mortgage with a higher rate, principal or amortization period, but this is something you will want to find out before you take out that first loan (and get in writing as well). The closed fixed rate mortgage does also offer the peace of mind that comes with a fixed rate. You don’t have to worry about rates going up during the term of the loan. However, if the interest rates skew downward, you end up losing money. Given that interest rates are already at historically low levels, it’s unlikely that the rates are going to go far enough down from this point to make that loss significant.
The process of qualifying for an open mortgage is similar to that of a closed mortgage, but obviously the bank will be looking at different parameters, including your ability to pay the note off in the shorter term. The price of the prepayment flexibility is a higher interest rate, but the fact that the terms are shorter means that the difference in rate ends up being a wash. The fact that rates are often variable with an open mortgage puts you at risk should rates spike, but the fact that most of these loans have terms that are in months rather than years keeps your risk less than with longer term variable rate mortgages.
Amansad Financial has helped clients get into both open and closed mortgages at a variety of terms. Talk to one of our lending specialists today to figure out the best solution for your needs.