Credit is an important part of commerce and in the lives of consumers. To finance the important purchases in life, banks and other financial institutions are available to provide customers with loans. An open mortgage has significant differences to a regular mortgage, or closed mortgage, which may suit your financial needs.
A mortgage is a loan to buy a home. It’s secured by the property, which means if the borrower is unable to repay, the bank has the right to foreclose. As with any loan, the lender collects interest to account for risk and to make a profit on the money lent. The cost of the property less the down payment is the amount loaned, regardless of any change in the value of the home. The maximum loan term is 25 to 30 years. There are variations, but the basic structure is interest on top of the principal. The payments at the start will mostly pay for interest. Towards the end, you’ll pay more and more of the principal.
Flexibility in paying more
An open mortgage is similar, except for the important point of repaying at a rate faster than allotted. There are many reasons that a homeowner might wish to eliminate their mortgage sooner rather than later. The closed mortgage permits some amount of prepayment, around 10% to 20% of the original principal loaned a year. Additional payments to the lender beyond that amount leads to penalties that don’t go toward the mortgage.
If you have uneven income or expenses leading to an irregular but sizable surplus, you may consider an open mortgage. The flexibility comes at a cost, which is an estimated 1% interest rate above a closed mortgage.
Is the interest rate worth it?
The penalty calculation is not always transparent. It can be quite hefty. It can also be small enough to be absorbed by the lower interest rate of a closed mortgage. It is this calculation that should determine which product you should choose.
Looking closely at the calculation
It’s not entirely transparent how each bank calculates their penalties. Some years ago the industry convention was to charge up to three months worth of interest on the remaining balance. Instead, the Interest Rate Differential (IRD) can raise the amount to a five-figure penalty due at once on fixed-rate mortgages.
Breaking down the IRD
The IRD has different parts built in to maximize the amount it can justify charging. As an example, say that you’ve had your mortgage for over three years. They will be comparing your interest rate to loans lasting two to three years. If your rate is highest, they will calculate your penalty as stated above. Otherwise, the lower rate out of the two and three year loan will be chosen. Sometimes the lower rate is the one used for preferred customers, which is not one usually available to the general market. The difference between your rate and the lower rate is applied to the remaining term. Whichever penalty is larger will be used.
The Interest Act is supposed to protect consumers. They put a limitation on the term length used for comparison. The maximum is five years.
Variable-rate mortgages are not affected by the IRD. The simple three-month calculation is used for all penalties.
Some buyers purchase starter homes with the intention of upgrading in the future. This can be true for young homeowners who intend on starting a family. Others may have wished to plant roots but decide to leave for reasons such as relocating for work. It can be complicated calculating the costs, and the possibility of penalty may be something you wish to avoid completely. Also, a few lenders will not permit leaving the contract early.
If you anticipate a steady income over the life of the loan, a closed mortgage is clearly the better choice, since the interest rate is more affordable. An income is set to increase along with expenses so that the remainder doesn’t leave much extra for early repayment, meaning an open mortgage is not the best option. In such cases, you can have the help of mortgage brokers in Ontario to choose the type of mortgage that suits your home the best. Furthermore, when paying off the mortgage early is not the priority, you should opt for the lowest interest rate possible. Extra cash can go towards other expenditures, such as travel or towards a new vehicle. Finally, if you are confident in investing and can see a return that is greater than the interest rate, a closed mortgage allows for slow repayment at lower lending rates.
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Lori J Sanders was born and raised in Toronto. She has been a proponent of business education, investing, a self-help author and a motivational speaker. She operates on her own blog and she speaks up on whatever that comes to her mind about finance, investment, mortgage renewals. With various real-estate investments, she retired at the age of 46. But she still continues to operate external business ventures and various investments. For more information, follow her on twitter.