Open vs. closed mortgages: what's the difference?

When it comes to paying off your mortgage, you need to decide between two payment structures: an open-end vs. a closed-end mortgage. The one you choose determines whether you’ll have the option to make increased or additional prepayments, or pay off your mortgage early — and there are financial penalties if you break the terms of your contract.

But before you commit to one or the other, there are a few important things to know about the difference between open and closed mortgages.

What is an open mortgage?

The definition of an open mortgage is pretty straightforward: the entire mortgage balance can be paid off in part or in full at any time, and the contract can be refinanced or renegotiated without penalty. That’s what makes an open mortgage so appealing — you can pay it off early or convert to another term without a prepayment charge.

Open mortgage terms are usually shorter, between six months and five years. Open mortgages are less common in Canada, but they’re an option if you want to deviate from the typical longer-term repayment schedule and pay off your mortgage early.

The tradeoff for the flexibility is that interest rates for open mortgages are higher compared to closed mortgage rates. With an open mortgage, you’ll likely end up paying the prime rate plus a substantial premium.

What is a closed mortgage?

A closed mortgage is pretty much the opposite of an open one. Closed mortgages have more restrictions and limited flexibility for borrowers: you can’t pay off the loan early, refinance or renegotiate the terms without incurring a penalty. However, interest rates for closed mortgages tend to be lower than rates for open mortgages.

Some closed mortgages do offer prepayment privileges. Prepayment privileges allow you to increase your monthly payments by a certain percentage, or pay an annual lump sum up to a percentage of the mortgage balance. Every lender sets its own prepayment terms.

Closed mortgages are the more popular choice in Canada because most people don’t plan to pay off their mortgage in the short term. Closed mortgage terms vary in length from six months to 10 years.

Closed mortgage prepayment penalties

Prepayment penalties (also known as break fees) for a closed mortgage depend on whether your interest rate is fixed or variable.

For a variable-rate mortgage, the penalty is usually three months of interest. For a fixed-rate mortgage, the break fee is either three months of interest or the interest rate differential (IRD), whichever is greater.

With interest rates at all-time lows, borrowers are almost guaranteed to pay the IRD, and that’s often a nasty surprise to Canadians who failed to read the fine print of their mortgage contract. It’s also important to go over your mortgage contract to find out exactly how your mortgage lender calculates IRD, because there are a few different ways to do it.

The standard IRD calculation uses the difference between two interest rates: the annual interest rate in your mortgage contract, and the lender’s posted rate closest in duration to the remainder of your term. Other lenders use the discounted IRD calculation, which uses the difference between the annual interest rate in your mortgage contract and the lender’s posted rate closest in duration to the remainder of your term, less any discount you received on your initial rate.

These calculations can be confusing, and lenders have their own ways of calculating IRD using different interest rates. It’s best to talk to a mortgage broker about your options, and clarify exactly how the IRD for your particular mortgage contract is calculated.

Open vs. closed variable-rate mortgages

There are also a few differences between closed vs. open mortgage rates depending on whether the interest rate itself is fixed or variable. The main difference between a variable closed vs. variable open mortgage is that variable rates can change depending on market conditions but a fixed rate stays the same throughout the entire mortgage term.

An open mortgage gives you the flexibility to make increased or additional mortgage payments, pay off your mortgage in full early, and refinance or renegotiate your contract. Variable interest rates are flexible too, but in a different way — your interest rate can go up or down if your bank raises or lowers its prime lending rate. While variable rates tend to be lower than fixed ones, open mortgage rates are generally higher to compensate lenders for the added flexibility. But if interest rates start to go up, an open mortgage allows you to switch to a fixed rate at any time.

Variable interest rates may be subject to change, but the repayment terms of closed mortgages are set in stone. With this type of mortgage, it’s important to know what your options are for making prepayments, and whether you can port your mortgage if you move to a new home. Most variable rate mortgages allow you to break your contract with a penalty of three months’ interest on your remaining mortgage balance.

Open vs. closed fixed-rate mortgages

A closed fixed mortgage is the least flexible — or the most stable, depending on how you look at it. Your interest rate will always stay the same, and you’re committed to fixed payments on a set schedule for your chosen term (six months to 10 years). Fixed rates on closed mortgages will be lower compared to open mortgage rates.

With an open fixed rate mortgage, interest rates will be high because they offer the security of locking in a particular interest rate while allowing the flexibility of extra payments or paying off your mortgage in full. Fixed open mortgages are designed to be short-term loans, with terms between six months to one year.

Should I go with an open or closed mortgage?

You might choose an open mortgage if you plan to move within the next year or two, or if you anticipate being able to make additional payments toward your mortgage because you receive extra money from a family inheritance, a bonus or increase in income at work, or the sale of another property.

A closed mortgage, on the other hand, may be the right choice if you want to stick to a predictable payment schedule and don’t think your personal circumstances will change during the period of your mortgage term.

All that said, it's not just about getting the lowest interest rate — there are several variables at play when you get a mortgage. Get a quote for your personal situation and talk to a mortgage broker.