The volatility of mortgage rates has left many Canadians guessing when it comes to what mortgage best suits their needs. Many people were left wondering what the best options were. Should you choose a fixed vs variable mortgage? An open vs closed mortgage? And how long should your term be? Let’s talk about it.
During the pandemic, when the Bank of Canada dropped their overnight rate to 0.25%, many borrowers took variable interest rates to maximize their borrowing power against the stress test.
Once the Bank of Canada started their rate hiking cycle, fixed mortgages quickly fell back into favour with homebuyers. They became the cheaper and safer option. During that time, many variable rate holders elected to jump off the rollercoaster and lock in a fixed mortgage rate. This luxury was brought to them by the “openness” of variable-rate mortgages.
Mortgages can be broadly grouped into two categories: open or closed.
What is an Open Mortgage?
Open mortgages, which variable mortgages most commonly are, allow you the flexibility of being able to repay all or part of your mortgage at any time during the term with little to no prepayment penalty.
Repayment can take the following forms:
- Using your cash to repay the mortgage;
- Selling your property and repaying the mortgage with the proceeds or
- Getting a new mortgage and repaying the mortgage with it.
The final option would be akin to “locking in” to a fixed-rate mortgage, more commonly seen as a closed-rate mortgage.
The Pros and Cons of an Open Mortgage
There are several advantages to having an open mortgage:
- Increase or decrease your regular payments with little or no penalty.
- Make lump sum payments on your mortgage anytime with little or no penalty.
- Refinancing your mortgage is cheaper and more flexible.
- You can sell the property at any time.
The only major disadvantage to an open mortgage is the risk of paying a higher premium on your mortgage rates than an equivalent closed mortgage. There are many reasons why this is the case – but it primarily is related to the way banks finance your mortgage.
For the most part, borrowers have no problem paying a premium for the flexibility of an open mortgage due to something called liquidity preference theory, which suggests that people prefer to keep assets more liquid (such as cash) rather than assets that require time and a sale to be liquid (like stocks or real estate).
Because of this liquidity preference, borrowers are willing to pay a bit of a premium. By “liquid,” we mean more repayable or accessible to change or remove.
How Does an Open Mortgage Work?
Open mortgages offer borrowers the advantage of flexible repayment options, allowing them to pay off their mortgage faster and make changes to their mortgage terms with ease. However, the trade-off is often higher interest rates, as borrowers pay a premium for the liquidity and freedom of open mortgages.
Repayment options include using personal savings, selling the property and using the proceeds to pay off the mortgage, or obtaining a new mortgage to settle the existing one.
Choosing this final option effectively transitions the mortgage into a fixed-rate mortgage, typically categorized as a closed-rate mortgage.
What is a Closed Mortgage?
Closed mortgages, on the other hand, do not allow the flexibility of being able to repay your mortgage during the time without a hefty penalty – usually the higher of an amount equal to three months’ interest on what you still owe or the interest rate differential (IRD).
Paying an interest rate differential penalty is like paying out the remaining interest on the mortgage term. The lender calculates this type of penalty by subtracting the posted rate when you signed your mortgage contract from the current posted rate for a term with a similar length. The lender would then apply this differential to the remaining balance on your mortgage, and that would be your penalty. However, it’s not all bad.
The Pros and Cons of a Closed Mortgage
There are several advantages to closed mortgage rates — most notably, these mortgages come with lower mortgage rates because the lenders don’t have to model in a potential liquidity event on their capital-raising efforts for these mortgages.
For example, the bank could lend you a five-year mortgage and issue a series of five-year Guaranteed Investment Certificates (GICs) and use that GIC deposit capital to fund the mortgages without any risk of the mortgages liquidating and causing problems for the GICs.
This is how they can offer lower rates. But they also include heavier penalties to compensate for the inconvenience and reconfiguration required to balance their books.
There are disadvantages to closed mortgages as well — most notably the penalties above. You cannot change your regular payment on a closed mortgage without refinancing or using an agreed-upon prepayment privilege within the contract.
How Does a Closed Mortgage Work?
Closed mortgages typically have a fixed term, meaning you agree to a predetermined fixed term, such as one, three, five, or ten years, where you agree to a specific rate and payment schedule.
During this period, the mortgage has a fixed interest rate, which means the rate does not change for the term, and your monthly mortgage payments are consistent. Many borrowers prefer this type of arrangement due to the predictability of the payments. This is why the five-year fixed mortgage has been the most popular mortgage rate in Canadian history.
Unlike open mortgages, there are pre-payment penalties as there are restrictions on making extra payments. This produces limited flexibility; you can’t refinance or renegotiate the mortgage terms without incurring penalties until the term ends. It is ideal for those who want a longer term, such as those buying a house to live in for a long time, with an option to renew the mortgage loan.
How Do You Choose Between an Open or Closed Mortgage?
There are several ways you can decide between open and closed mortgages. Let’s look at the key differences between the open and closed mortgages. Open mortgages, more commonly variable rates, are ideal for risk-takers who don’t mind a fluctuating market, while closed mortgages are ideal for people who want fixed payments without fluctuation.
An open mortgage can be ideal for buyers seeking shorter terms or those uncertain if they plan to move within the period of a mortgage term – for example, five years. The closed mortgage is the opposite and ideal for longer terms and those who don’t plan to move or make changes.
Lastly, an open mortgage can be suitable for those who want to make additional payments towards the mortgage, while a closed mortgage works for those who want predictable payments rather than flexibility.
