For new home buyers, the variety of mortgage types and nuances of each can be bewildering. Choosing the right type of mortgage can impact your payments in the short term. It can also impact your future finances by adding or saving thousands of dollars in interest over the lifetime of your mortgage. Sometimes, even seasoned homeowners don’t realize the costs involved if they want to break their mortgage early or repay it faster than expected.
Typically, when people apply for their first mortgage, simply settling into their new home with payments they can afford is the goal. But as time goes on, you may start to think about the possibility of repaying faster. The type of mortgage you choose, either open or closed, can impact whether repaying faster is possible or if it will even save you any money at all.
Closed Mortgages and Open Mortgages
The terms and conditions of any mortgage include rules stating the principal amount allowed to be pre-paid during the mortgage term. The terms will also state the costs you will incur if you decide to break the mortgage agreement and repay it all sooner. Mortgages that allow you to repay the entire balance of the mortgage without penalty during the term are called open mortgages. The most popular type of open mortgage offered today is the home equity line of credit (HELOC). These are fully open mortgages that are re-advanceable, require interest-only payments and can be paid in full at any time.
Closed mortgages on the other hand, typically only allow you to prepay a small portion of the principal without penalty – usually 10%-20% or less per year on top of your regular payments. Closed mortgages (especially those with fixed-rate terms) often come with incredibly steep penalties for breaking the mortgage early. Unfortunately, many banks don’t make this clear to clients signing them up. In fact, they count on the fact approximately 60% of borrowers will break a 5-year fixed-rate mortgage and pay a big penalty before the term is up!
The choice seems obvious. But is it?
When you’re weighing your options between a mortgage with lots of flexibility to repay faster and one that doesn’t, the choice seems clear. An open mortgage could save you a ton in interest over the lifetime of your mortgage if aggressively paying off. However, closed mortgages offer significantly lower interest rates than open mortgages. The reason for this is that lenders need to compensate for the potential loss of interest income should you pay your mortgage out early.
Of course, that’s not the whole story. And you shouldn’t choose your mortgage based on interest rate alone.
How to Decide on an Open or Closed Mortgage
People get ambitious once they find out how much they are paying in interest at the start of their mortgage. It inspires them to dream of repaying faster as their income rises or their financial situation makes it possible to do so. The financially savvy may even know that paying down the principal early in the life of the mortgage is the best way to gain the biggest overall savings in interest.
While that is absolutely true, there are other nearly universal truths out there. For instance, at the time of life when people are typically purchasing their first home is also the time when they experience many other large expenses such as student loans, daycare costs, and vehicle loans. Most people are also not at the peak of earning power during this time, with parental leave and other career uncertainties. The reality for most homeowners is that they simply can’t afford to pay off a significant amount of additional principal above and beyond their regular payments in their first few years of ownership.
A fine balance between the closed fixed rate mortgage and the fully open mortgage that I often recommend is the closed variable rate mortgage with a fixed payment. This unique mortgage product provides borrowers with the cost certainty of the fixed payment throughout the term, the low rate of the closed variable mortgage and the flexibility of the variable which allows full prepayment of the mortgage with only a three month interest penalty.
Your Time May Come for an Open Mortgage
One day you may find yourself in the position to pay off more than 15% per year of your principal or to repay the balance entirely. When that happens, you should consider an open mortgage the next time you renew. Until then, you may be better off sticking to a lower interest rate closed mortgage. If possible, take advantage of the smaller repayment options, which can still have an impact over time.
Changing from monthly to weekly or bi-weekly payments can help save a little bit in interest over the long haul. Accelerated payments increase your payments by only a few dollars, but the additional amount goes fully towards reducing the principal. If you do occasionally find yourself with a little extra cash, some closed mortgages will allow you to double up on payments.
Whether you are buying your very first home or need to renew your mortgage, talk to a mortgage broker to get expert advice on the type of mortgage that best fits your financial needs. There’s no one mortgage that fits everyone, and your needs change over time. Harrison White at HW Advantage will help find the mortgage that best suits you now and in the future. Call for a consultation today!