What is a Closed Mortgage?
A closed mortgage means that the terms a homeowner agrees to when they sign their mortgage contract can not change throughout the mortgage term, without paying a penalty.
Though the interest rate for a closed mortgage is generally lower than an open mortgage, they typically only allow a limited amount of the principal to be prepaid without an additional charge, and, when the homeowner decides to sell, they will likely be forced to break the mortgage and pay the associated penalties and fees.
Closed mortgages are primarily fixed-rate mortgages, which protect homeowners from rising interest rates.
Why is this term important?
Understanding the options when it comes to mortgages is important as it allows a buyer to make the best decision for their unique situation.
For owners who do not see themselves selling or refinancing their home in the near future, and don’t intend to make extra payments towards their mortgage, a closed mortgage may be the better option because of its lower interest rate.
Here is an example:
Let’s say a homeowner receives a $500,000 closed mortgage to purchase a home. The loan has a term of 5 years with a fixed interest rate of 5%. In this example, the closed mortgage states that any prepayment above a 10% lump sum each year will incur a penalty.
After owning the home for a year, the owner gets a significant inheritance and decides to put these funds toward their mortgage principal. But, since the lump sum they want to make is 13% of their mortgage principal, it is above the 10% limit and would be subject to a prepayment penalty. A year later, they get a job offer in another province and sell the home, breaking their mortgage early. Since they have a closed mortgage, they will be charged a penalty for breaking the mortgage within the 5 year term.