For anyone exploring mortgage options, keep reading!
The Two Mortgage Types Available
The vast majority of mortgages in Canada are closed mortgages. A closed mortgage means the mortgage has limits to how much can be repaid before maturity without the borrower incurring a penalty. An open mortgage means that the entire mortgage can be repaid at any time without any penalty.
The Cost of Freedom
Your first thought may be that you don’t want to be tied down with any restrictions, in which case getting an open mortgage makes the most sense. You’ll quickly find that the cost is substantial to do so. As of today, an open mortgage fixed rate is roughly 4.50% whereas a competitive closed mortgage fixed rate would be closer to 1.80% (see our current rates). Assuming a 25-year amortization and $400,000 mortgage balance, monthly mortgage payments under those 2 rates respectively would be $2,214 and $1,655. You’d be paying almost $600/month extra just to get an open mortgage rate.
The Illusion of Freedom
The word “closed mortgage” can be misleading, as it implies there are no repayment terms. A closed mortgage usually allows for early repayments without penalties. This is defined as a mortgage payment increase and lump sum repayment amount. The industry standard you may be familiar with is “15/15”. It means you can increase your mortgage payments by 15% per year and/or prepay 15% of their original mortgage amount without any penalties. Let’s calculate what that could look assuming a $400,000 mortgage at 1.80% with a 25-year amortization:
- Assuming rates stay the same, if you make the standard monthly payment of $1,655, you will pay your mortgage off in full over 25 years If you increase your mortgage payments by 15% each year, you would pay off your mortgage in 10.5 years. This translates to increasing mortgage payments by $300/month each year.
- If you pay off 15% of your original mortgage amount each year, you’d pay your mortgage off within 6 years. This translates to prepaying $60,000 in principal once per year.
Putting ourselves in the shoes of the average borrower, it’s highly unlikely that they would have the ability to increase their mortgage payments by 15% and prepay 15% of the mortgage balance each year. As a matter of fact, many borrowers don’t leverage their full prepayment privileges (or even at all in some cases) and this benefit is largely under utilized but overemphasized. It’s like when your cellphone company tries to sell you on a 10GB/month data plan, but you only use 2GB….paying for excess is a waste of your money.
So if open mortgages are so expensive, why do they exist?
When Open Makes Sense
An open mortgage is meant to be a short-term solution when timing is not on your side. Here’s a few scenarios where this would apply:
- You’re actively trying to sell your home, but won’t be able to close on the sale before your mortgage maturity date. Renewing into an open mortgage enables you to drag out your mortgage maturity date and then immediately pay off your old mortgage after you sell your home without any penalties. Otherwise, if you renew into a new mortgage term you would be exposed to a full penalty on a brand new term.
- You are soon expecting a large cash inflow (ex: bonus or inheritance) that you want to use to prepay your mortgage above the prepayment allowance limit. You could renew into an open term, pay down the principal and then convert your open mortgage into a closed mortgage rate once you settle on the mortgage amount you want to carry.
The key theme in these scenarios is that you just need a bit more time. Open mortgages are meant to be a short-term solution (3 months at the most). Otherwise, you’re almost always better off just getting a shorter term closed mortgage (ex: 6-month or 1 year) or a closed mortgage that is relatively inexpensive to break.