What Is a Closed Mortgage and How Does It Work?

Among the common options available, a closed mortgage stands out as a prevalent choice, offering a structured approach to home financing. This type of mortgage establishes a clear repayment path, defining the terms and conditions for a specific period.

What Defines a Closed Mortgage

A closed mortgage is characterized by a fixed contractual term during which the borrower agrees to specific payment terms and interest rates. This structure provides stability, as payments remain predictable over the agreed-upon period. Unlike some other mortgage types, a closed mortgage typically limits the borrower’s ability to make early repayments or significantly alter the loan’s terms without incurring additional charges.

This commitment benefits both the borrower, through payment consistency, and the lender, by ensuring a predictable income stream for the duration of the term. While restrictive, this design often translates into more favorable interest rates compared to more flexible alternatives.

Key Features of Closed Mortgages

Closed mortgages come with specific attributes that shape their functionality and appeal. The duration of a closed term can vary, commonly ranging from six months to 10 years, with a five-year term often being a popular choice for many borrowers. Within this defined term, the interest rate can be either fixed, meaning it remains constant for the entire period, or variable, fluctuating based on market rates while still adhering to the closed term agreement.

A defining characteristic of closed mortgages is the presence of prepayment penalties. These penalties are fees charged if a borrower pays down a significant portion of the principal, refinances, or fully pays off the mortgage before the agreed-upon term ends. Lenders impose these penalties to recover lost interest income that they anticipated earning over the full term of the loan.

Common calculation methods for these penalties include a set number of months’ interest, typically three months, or an interest rate differential (IRD) calculation. The IRD calculation often involves determining the difference between the original mortgage interest rate and the current market rate for a similar term, then multiplying this difference by the outstanding balance and the remaining term. However, many closed mortgages do offer limited prepayment privileges, allowing borrowers to make small additional payments or annual lump-sum payments, often up to 10% or 20% of the original principal, without incurring a penalty.

Closed vs. Open Mortgages

The distinction between closed and open mortgages primarily revolves around flexibility and interest rates. Closed mortgages offer limited prepayment options and typically impose penalties for early repayment, whereas open mortgages allow borrowers to repay all or part of their mortgage at any time without incurring such charges. This unrestricted flexibility in an open mortgage can be beneficial for those expecting a significant financial windfall, such as an inheritance or proceeds from a home sale, which they intend to use to pay down their debt quickly.

Conversely, the stability and predictability of closed mortgages often come with lower interest rates compared to open mortgages. While an open mortgage provides payment flexibility, it typically features higher interest rates due to the increased risk for the lender. Therefore, the choice between a closed and open mortgage often depends on a borrower’s financial outlook and their need for payment flexibility versus the desire for a lower interest rate and predictable payments.