Photo: Mary Crandall/Flickr
The following is a guest post by Atrina Kouroshnia, a BC-based mortgage broker who specializes in mortgages for first-time homebuyers. She also created mortgage comparison site Lava Rates to help bring more transparency to the world of Canadian mortgages.
When you borrow money to buy a home, you will have the choice between an open mortgage (allows you to prepay any amount at any time without penalty) or a closed mortgage (imposes penalties for prepaying more than a set amount each year — typically 10 to 20 per cent).
Some buyers, especially older ones, often prefer open mortgages because they offer more flexibility and avoid mortgage prepayment penalties if the buyer wants to refinance, sell the property or pay off the mortgage early. Instinctually, the buyer may believe an open mortgage is better if he or she needs short-term financing before selling or refinancing a property. But often, the amount they pay in higher interest with an open mortgage actually exceeds the penalties they would have paid in a closed mortgage.
Suppose you were given these two options:
Closed mortgage: 5 years Fixed 2.94 percent or 5 years variable at prime – 0.55 = 2.45 percent (currently available from Scotia)*
Open mortgage: Prime + 0.8 percent = 3.8 per cent (currently available from Scotia through your broker)*
If you chose the closed mortgage and ended up staying in the home without refinancing or prepaying, you wouldn’t pay any penalties but you’d still enjoy the lower interest rate.
If you did decide to prepay on a closed mortgage, you would pay a penalty — typically equal to three month’s interest on your current mortgage or the interest rate differential (IRD), whichever one is higher. (The IRD equals the difference between your current mortgage rate and the rate that your lender could charge in present day by re-lending funds for the remaining term of the mortgage.)
To make this more clear, let’s say you had a $350,000 mortgage with a 25-year amortization and the interest portion of your monthly mortgage payment was $675. If you’d recently taken out the mortgage, the IRD might be small because interest rates are still relatively low. In that case, you’d owe three month’s interest as a prepayment penalty.
$675 x 3 months =$ 2,025
Keep in mind however, you may be subject to administrative or legal fees on top of the penalty when you prepay your mortgage.
Even with the penalty, you’d still come out ahead with a closed mortgage because it carries a much lower interest rate than the open mortgage. At 2.45 per cent, you’d pay about $2,000 to get out of your closed mortgage. With an open mortgage of 3.8 per cent, your monthly payments would be $250 higher and you’d be left with a higher balance due to the higher interest. Within the first year you would be looking at $1,000 extra in principal reduction with the closed mortgage in addition to the savings of $250/month.
($250/month x 12 months) + $1,000 (smaller ending balance) = $4,000
Now to compare the Closed vs. Open Mortgage:
$4,000 (savings with the closed mortgage) – 2,000 (penalty to exit a closed mortgage) = $2,000 ← Savings with the closed mortgage
The word penalty sounds scary, so many borrowers want to avoid them at all costs. But, an open mortgage carries a ‘penalty’ in another way – it’s just not called a penalty because it’s masquerading as a higher interest rate. Either way, you’re paying extra money, and for many people a higher interest rate feels less punishing than a prepayment penalty.
A closed mortgage with a lower interest rate makes sense for many buyers, even if they wind up paying a penalty. But if you’re unsure about your own situation, then you should consult a mortgage broker. He or she can help you run the numbers and understand which type of mortgage and interest rate best fits your needs.
*These are conservative rates — actual savings may be greater depending on the actual 5-year rate.