Definition of a Closed Mortgage
A closed mortgage is one that cannot be repaid without prepayment penalties during its term, except as permitted in the mortgage agreement. Closed mortgages will typically provide limited prepayment privileges, but will incur a penalty if the borrower pays any more towards the principal than the combined total of the normal monthly payment and these privileges.
The prepayment penalty will apply if the borrower exceeds the allowed prepayment privileges when increasing the monthly payments, making a partial principal reduction via lump sum payment or refinancing the mortgage before the end of the term.
1. Mr. McGillicuddy takes out a $200,000 mortgage at 4% interest and a 5 year term. Mr. McGillicuddy’s monthly payments are $951.04, assuming a 30 year amortization period. The mortgage provides that any prepayment above a 10% lump sum each year will incur a penalty of up to 3 monthly payments, or the Interest Rate Differential on the amount prepaid. If Mr. McGillicuddy pays more towards the principal than the monthly payments and the 10% lump sum annually, a penalty will apply.
2. In the same example as above, in year two of the mortgage, Mr. McGillicuddy finds a lender willing to refinance the mortgage at 3%. If Mr. McGillicuddy refinances the mortgage before the end of the five year term, a prepayment penalty will also apply.
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Advantages of a Closed Mortgage
Despite prepayment penalties, a closed mortgage has advantages to the right borrowers. If a borrower does not intend to sell the property in the foreseeable future, has no intention of prepaying any portion of the mortgage over an above what is allowed in the pre-payment privileges or has no intent to refinance the mortgage during the term, a closed mortgage may make financial sense. This is because closed mortgages usually come with a lower initial mortgage rate than fully open mortgages. If the borrower does not intend any type of prepayment for a number of years, it may be best not to pay the higher interest of an open end mortgage.
In addition, many closed mortgages are fixed rate mortgages, and if the prevailing mortgage rates are low when the mortgage is issued, the borrower has then locked in at a low interest rate, a good protection against rising interest rates.
Disadvantages of a Closed Mortgage
If an applicant is expecting to be able to pay their mortgage down or off entirely before the end of the mortgage term, sometimes an open term mortgage or a line of credit maybe a better choice for them. For instance, some clients maybe planning to sell a a vacation property or vehicle or perhaps they are expecting a large gift or an inheritance from a family member. If the funds they are anticipating exceed the allowed pre-payment privileges of a closed term mortgage, a short term closed mortgage, an open mortgage or a line of credit may be the more suitable products in this instance.
At First Foundation, we search for all types of mortgages for our customers, and do our best to explain the advantages and disadvantages of each before choosing a mortgage product. No one knows themselves better than the customer, and the final decision is theirs. For our part, we provide all information necessary to make an informed decision.
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