Open vs. Closed Terms
April 25, 2017 | Posted by: Shayne Beeler
I’ve noticed there is differing interpretation floating around among mortgage holders when it comes to “open vs. closed” mortgages. For example, I’ve heard someone allude to a 5-year fixed term as “an open mortgage” when really they have pre-payment privileges of 20% per year (they can pay up to 20% of the original mortgage amount each year without penalty).
The true definition of an “Open Mortgage” is one that can be paid off entirely, at any time, without penalty. The two primary examples are a Home Equity Line of Credit (HELOC) and an “Open Variable” term – the main difference between the two being the “HELOC” generally comes with an interest-only payment requirement whereas the “Open Variable” is structured within a term and scheduled based on an amortization.
I’ve met multiple mortgage holders who have purposely chosen a fully open mortgage because “they didn’t ever want to pay a payout penalty”. On the surface, the logic makes sense. But let’s take a closer look…. The key here lies within asking the question, “what costs more money out of my pocket”? The math answers this question – an “open variable term” is generally priced at Prime (2.70% at time of writing this) + 0.80% or 3.50%. Sounds pretty decent, doesn’t it? 3.5% and you can pay your mortgage off any time you want without penalties…. Let’s now look at a “Closed Variable Term”. Recall, closed terms still come with pre-payment options that allow somewhere between 15-20% of the principal to be paid each year without penalty but yes, a closed variable will cost us a penalty if we pay it out early. How much of a penalty? A 3-months interest charge on a standard product. Let’s take a $300,000 mortgage with a modest variable interest rate of Prime – 0.40%, 2.30% at time of writing. The full payout penalty in this case, would be roughly $1725. Let’s now compare this to an open variable term without a penalty. We’ll use a 25-year amortization to compare the two terms. The result in one year – the fully open term costs $3529.70 more in interest over just 12 months. After a little more than 6 months, you’d actually be further ahead by having a closed variable and paying the penalty on purpose instead of paying a higher interest rate for the ability to avoid a penalty.
In summary, “how do I avoid a penalty” is a valid question. But it’s not the only question. Let’s make sure we’re always digging further below the surface, to make sure we’re not paying for mortgage features we think we need while inadvertently paying more interest than we should be. Imagine holding an open term for 3 years because a sale of your home was on the horizon? Does $9000+ more in interest justify saving you a $1725 penalty? Certainly not, in this case. Please always consult your Mortgage Broker to discuss term options in full detail. There are always differences from one term to another and as you can see based on the math, these decisions can literally save you thousands.
