A closed mortgage is a home loan you must repay within the agreed conditions and time negotiated during the agreement. Also known as a closed-end mortgage, it cannot be renegotiated, refinanced, or prepaid without paying off breakage costs and other significant penalties to the lenders.
When planning to purchase a home, most homeowners will require a mortgage. However, there’s no one-size-fits-all mortgage, and you’ll need to look for the best that suits you best. Closed mortgages are ideal for homebuyers who are not planning to move soon and who are willing to agree to a longer-term commitment to reduced interest rates.
What is a closed-end mortgage?
Closed mortgages also disallow pledging collateral already committed to other parties. A closed-end mortgage is one of the most restrictive mortgage types. Once you sign the agreement, you cannot refinance the home, renegotiate the terms, or use it as equity.
Understanding Closed-End Mortgages
This mortgage type offers limited prepayment privileges. However, close-end mortgages also attract a payment penalty if you pay more to the principal than the combined total of the typical monthly payment and the privileges.
A prepayment penalty applies when you exceed the agreed payment privileges. This is done through increasing monthly mortgage payments, refinancing the mortgage before the term’s end, or making partial principal reductions through a lump sum payment.
Let’s assume you take out a $200,000 loan at a 4% interest rate and a five-year term. Your monthly mortgage payments will be $951.04, supposing a 30-year amortization frame. The mortgage provides that any prepayment over a 10% lump sum annually will attract a penalty of three monthly payments or the interest rate differential on the prepaid amount.
If you pay more towards the principal than the monthly payments and the 10% lump sum every year, the penalty will apply.
In the above example, you find a mortgage lender willing to refinance your mortgage at 3% in the second year of the mortgage. The prepayment penalties will apply if you refinance the mortgage before the five-year term ends.
Sometimes, mortgage lenders provide closed mortgages to mitigate risk when financing borrowers. Should you enter bankruptcy or default on the mortgage, the lender has ensured that no other lenders will claim the house as collateral through a closed-end mortgage. The lender can change the mortgage contract to offer reduced interest rates.
Open-End vs. Closed-End Mortgages
With closed mortgages, you cannot renegotiate, refinance, or repay until you’ve paid off the entire mortgage, or at least a substantial fee. However, closed mortgages come with lower interest rates, as lenders view them as low risks.
On the other hand, you can pay an open mortgage early. You can make payments at any time, meaning you can pay off your mortgage faster without incurring extra charges. Open-end mortgages, however, come with a higher interest rate.
Another form of mortgage is known as a “convertible mortgage.” Convertible mortgages borrow the characteristics of both open and closed mortgages to offer the best mortgage rates. While this may sound like the obvious choice, convertible mortgages also fluctuate with the change in interest rates. This is important to keep in mind when deciding upon the best mortgage for you.
Pros and Cons of a Closed-End Mortgage
Here is a list of the benefits and the drawbacks to consider.
- Closed mortgages offer low-interest rates due to the low risk.
- Interest rates and mortgage terms won’t change during the loan term.
- Ideal for a long-term mortgage to be repaid slowly and steadily.
- No flexibility. If you get a huge amount of money and want to pay off your mortgage quickly, you can’t.
- Not ideal for individuals with developing careers (open-end mortgage allows for tailored repayments based on income).
How to choose between open vs. closed mortgages
When applying for a mortgage, deciding between a closed or an open mortgage isn’t the only determining factor. The interest rates can either be fixed or variable. Lenders will typically give various combinations of closed and open, fixed-rate, and variable mortgages.
The fixed rates are normally higher than variable rates since they get the stability of the mortgage rates for the entire loan term, even if the interest rates increase. A fixed-rate could be ideal if you prefer a stable interest rate to help you budget correctly or believe the rates might increase during the loan term. On the other hand, the variable rate could be best if you can monitor the changes in interest rates, absorb the possible increase, and believe the rates will remain stable.
If you can take out a home equity line—for instance, if your primary mortgage is open-end—your new financing could be a closed-end second mortgage. This financing type can’t allow you to take out more money against the property, unlike a home equity line of credit (HELOC).
If you’re planning to take a closed mortgage, ensure you fully review and understand the terms and conditions. While the low-interest rates could attract you, you’ll be limited on how to structure your finances. For instance, if you want to pay your loan early, you’ll incur a penalty.
How do I get out of a closed mortgage?
It varies by lender, but you can often get out of a closed mortgage by paying a penalty of three months’ interest.
Is an open or closed mortgage better?
This depends on your personal finance and personal situation. Closed mortgages have more restrictions but a lower interest rate, and open mortgages allow for different payment amounts but may lead to larger interest payments depending on the market.
Can you pay off a closed mortgage early?
A closed mortgage will allow you to make extra payments of up to 20% of the mortgage principal annually. Also, you can increase the monthly payment by 20% annually and increase the monthly mortgage payment by $50 minimum and up to 20% maximum on the agreed payment amount per year.
- A closed mortgage is a home loan or mortgage type you must pay back within the agreed conditions and time negotiated during the mortgage contract.
- A closed mortgage also disallows pledging collateral that has already been pledged to other parties.
- The main benefit of closed mortgages is their low-interest rates.
- The main downside of closed mortgages is the fact you lose flexibility. For instance, if you get a huge amount of money and want to pay off your mortgage faster, you can’t.
View Article Sources
- Closed, open and convertible mortgages — RBC Royal Bank
- Schedule RC-P – FDIC
- Best Mortgage Lenders for First-Time Homebuyers | January 2022 — SuperMoney
- How to Finance a House — SuperMoney
- Best Mortgage Lenders | January 2022 — SuperMoney
- 2021 Mortgage Industry Study — SuperMoney