Closed mortgages are the most popular mortgage option for Canadian homebuyers. With over 80% of borrowers opting for closed terms, these mortgages dominate the market.
But what exactly are closed mortgages, and why are they so widely used in Canada? This comprehensive guide will explain everything you need to know about this type of mortgages, from how they work to their advantages and disadvantages.
Read on for expert insights to help you determine if a closed mortgage is the right choice for your home purchase or renewal.
What is a Closed Mortgage?
A closed mortgage is a mortgage that cannot be repaid in full before maturity without prepayment penalties, except as permitted in the mortgage agreement itself. The original principal cannot be reused or extended once repaid.
Most closed mortgages provide some prepayment privileges, allowing lump sum payments of up to 10% (except for some lenders that offer a portion of 15% to 20%) of the original principal annually. However, exceeding these limits triggers stiff penalties from the lender.
(Source: https://www.rbcroyalbank.com/mortgages/mortgage-prepayment.html)
For example, a homebuyer is approved for a $300,000 closed-end mortgage with a 5-year term and a 4% interest rate. The monthly payments would be around $1,578.06.
The mortgage agreement allows lump sum prepayments of 10% of the original principal per year. If the borrower pays more than their regular payments plus 10% of $300,000 before the 5-year term ends, they will incur prepayment charges which equals to 3 month’s interest ($3000).
How Do Closed Mortgages Work?
Closed mortgages provide a lump sum of financing upfront, which the borrower repays through regular principal and interest payments over a set period. The amortization period is typically 25-30 years, but the mortgage term itself can range from 6 months to 10 years.
The interest rate on a closed mortgage can be fixed for the entire term or variable and tied to the prime rate.
Fixed Rate
- Interest rate stays the same for the full term
- Payments don’t fluctuate, and they are easy to budget
- Protects against rising rate environment
- Typically, it has higher penalties
Variable Rate
- Interest rate floats with the prime rate
- Payments increase or decrease with rate changes
- Benefit from falling prime rate
- Usually has lower prepayment penalties
Once the term expires, the mortgage can be renewed at current market rates. This mortgages use the property as collateral, meaning the lender can seize it if the borrower defaults on payments.
Unlike lines of credit or open mortgages, closed mortgages do not allow the principal balance to be reused. Even as regular payments reduce the principal owing, the loan’s original amount cannot be extended or borrowed against again. They are one-time loans that must be fully repaid by the end of the term.
When deciding between open and closed mortgages, the flexibility and prepayment differences are key considerations:
Open Mortgages
- Allow prepayment of any amount without penalties
- Can be easily refinanced at lower rates if rates drop
- Higher interest rates than closed mortgages
- Require full monthly amortized payments
Closed Mortgages
- Limit prepayments to avoid penalties
- Lock in an interest rate for the full term
- Lower interest rates than open mortgages
- A single lump sum means lower monthly payments
Ultimately, closed mortgages offer savings on interest costs, while open mortgages provide more flexibility and control.
Other factors to consider
Beyond open mortgages, other alternatives may make sense depending on your situation:
Convertible mortgage – This lets borrowers convert to a longer fixed term after a short period, typically 6 months.
Home Equity Line of Credit (HELOC) – Provides revolving access to funds secured by home equity, with flexibility to repay amounts borrowed.
Hybrid Mortgage – Combines features of fixed and variable mortgages, allowing rate conversion within a single term.
Advantages of Closed Mortgages
Closed mortgages have several key advantages that make them the most popular mortgage option:
Lower Interest Rates – The biggest appeal is lower interest rates, averaging 1% below open mortgage rates. These interest savings accumulate to thousands of dollars over the mortgage term.
For example, a 5-year fixed-rate closed mortgage currently averages 4.5%, whereas 5-year open mortgages average around 5.3%. On a $300,000 mortgage, this 0.8% rate difference equals $2,400 in savings per year or $12,000 over the full 5-year term.
Rate Protection – Fixed closed terms lock in an interest rate, protecting borrowers if rates trend higher. For instance, by locking in a 3% rate in 2024 for a 5-year term, homeowners protected themselves from rising fixed mortgage rates to over 5% in 2026. Their rate and payments stayed stable, which reduced uncertainty.
Fixed Payments – Closed mortgages with fixed interest rates have regular, predictable payments that won’t fluctuate. This helps with budgeting.
Lower Fees – Aside from potential prepayment penalties, closed mortgages have lower fees than other products like lines of credit.
Easier Approval – Lenders view closed mortgages as lower risk, so borrowers may find it easier to qualify compared to open mortgages.
Better Cashflow – The single lump sum means lower monthly payments compared to an amortized open mortgage with the same principal.
Disadvantages of Closed Mortgages
There are also some downsides to be aware of:
Prepayment Penalties – Exceeding annual prepayment allowances triggers penalties, as does refinancing before maturity. These penalties can be costly.
A homeowner with a $400,000 mortgage at 4% prepays $100,000 over their annual 15% limit may face a penalty of 3 months of interest on the $100,000, costing them $1,000.
Less Flexibility – Closed terms lock borrowers in until maturity. Taking advantage of better rates, making large prepayments, or switching lenders is difficult. If rates fall, borrowers forgo savings by being locked in at a higher rate.
For example, homeowners locked into a 5-year fixed term at 4% cannot refinance or switch lenders without facing potentially expensive penalties if mortgage rates dropped to 3%.
More Prepayment Interest – The inability to make large lump sum payments means more interest is paid over time compared to an open mortgage.
Variable Uncertainty – While variable closed mortgages let borrowers benefit from rate drops, payments fluctuate with prime rate hikes.
Strict Terms – Have stricter requirements regarding insurance, loan-to-value ratios, payment frequency, and increasing payments.
Why do Canadians choose Closed Mortgages?
Over 80% of Canadian homebuyers choose closed mortgages, and for good reason:
- Meet Most Needs – For most Canadians, the prepayment restrictions are a worthwhile tradeoff for lower rates and big interest savings. Closed terms adequately meet their needs. Most people don’t need the extra flexibility of open mortgages.
- Familiar and Accessible – Banks heavily market closed terms. Most buyers stick with what they know and can quickly obtain.
- Stable Housing Market – Canadian home values are not volatile. Owners don’t need to rapidly prepay mortgages. Closed terms suffice.
- Peace of Mind – Canadians value the certainty of fixed repayments. Open mortgages seem riskier or more confusing to many.
What are Closed Mortgage Prepayment Penalties?
Prepayment penalties are the tradeoff that comes with closed-end mortgages in exchange for lower rates. Rules and fees vary between lenders, but penalties generally apply when:
- The annual prepayment allowance is exceeded
- The mortgage is refinanced or switched to another lender before maturity
- The mortgage is paid off in full before the end of the closed term
Understanding the prepayment charges is critical when comparing closed mortgage offers:
- Amount: The higher amount of 3 months of interest or interest rate differential (IRD) on the amount prepaid
- Annual Limit: 10-20% of original principal
- Term Length: Shorter terms have lower penalties. 3-year terms often have lower prepayment fees than 5 years.
- Variable Rate: Usually smaller penalties than fixed-rate mortgages
Who Should Consider a Closed Mortgage?
Closed mortgages are best suited for the following types of borrowers:
First-Time Homebuyers
Many first-time homebuyers gravitate towards closed-end mortgages because they offer lower rates and payments than open mortgages. The predictability of fixed payments also appeals to new homeowners working on tight budgets.
Long-Term Owners
Owners who plan to stay in their home for the long run, such as for 10-25 years or more, benefit from the interest savings of a closed mortgage. Shorter-term owners would miss out on entire savings due to potential penalties if they sell before maturity.
Conservative Borrowers
Closed mortgages appeal to fiscally conservative homeowners who are averse to financial risks. The certainty of fixed mortgage payments gives risk-averse borrowers peace of mind.
Retirees and Fixed Income
Retired Canadians living on fixed pensions and other incomes favour the reliability of closed mortgage payments. Sudden payment increases from an open mortgage could severely impact budgets.
First-Time Immigrants
New immigrants from countries with different mortgage systems often gravitate towards the familiarity of closed terms. In comparison, open mortgages seem complex and risky.
Lower Income Households
Borrowers focused primarily on affordability may choose this mortgage type to capitalize on the lowest rates and payments. Rate savings matter more than flexibility.
Qualifying for a Closed Mortgage
The qualification process for closed mortgages is similar to that of open mortgages. The lender will review:
- Income and employment status
- Existing debts and liabilities
- Credit score and history
- Down payment amount
- Assets and net worth
Meeting the lender’s debt-to-income ratios and minimum credit scores is critical to getting approved. Having a larger down payment and some cushion in your finances also helps improve your chances of qualifying.
Getting pre-approved makes the mortgage search and negotiating process more accessible. Working with an experienced broker can also streamline finding the best closed mortgage.
How to find the Best Closed Mortgage in Canada?
Follow these tips when searching for your mortgage in Canada:
- Compare rates to get the most competitive offers.
- Ask about prepayment options to maintain flexibility. Some lenders offer 10-20% annual lump sum allowances.
- Review all fees like application, appraisal, and discharge fees. The lowest rate may not be the cheapest overall.
- Consider a blend: A combo of fixed and variable rates or short and long amortization periods can optimize savings.
- Get pre-approved to show sellers you are serious and improve bargaining power.
- Work with a broker to quickly compare many lenders and find you the best closed mortgage.
Closed Mortgage in Canada: Key Takeaways
- Most Canadian homeowners choose closed-term mortgages to benefit from the thousands in interest savings.
- Provide a lump sum of financing repaid over a set term through regular payments.
- Offer lower rates but limit prepayment flexibility compared to open mortgages.
- Closed terms are best for borrowers who value low rates and can accept some restrictions.
- Understanding options like variable rate, short-term, and convertible closed mortgages maximize choice.
- Penalties apply if prepayment allowances are exceeded or the mortgage is refinanced before maturity.
By taking the time to understand factors like mortgage term lengths, fixed vs variable rates, prepayment rules and penalties, you can find the ideal mortgage for your situation.
At Best Mortgage Online, our experts can help you find the perfect mortgage option to maximize savings and make home financing affordable. Whether buying your first home or renewing an existing mortgage, we’re here to provide guidance and support every step of the way.
Visit Best Mortgage Online.ca to take the first step to securing your ideal closed mortgage and see how much you can save today!
FAQs
What are the downsides of closed mortgages in Canada?
Potential downsides of closed mortgages in Canada include a lack of flexibility, prepayment penalties, and missed savings if rates fall.
Should I get a closed or open mortgage in Canada?
Choose closed for lower rates and fixed payments. Choose open if you value the flexibility to prepay, refinance when rates drop, and avoid penalties.
What is the difference between fixed and variable closed mortgages in Canada?
Fixed closed mortgages have a locked-in rate, while variable closed rates float with the prime rate. Fixed rates provide payment stability.
Who is best suited for a closed mortgage in Canada?
First-time buyers, long-term owners, risk-averse borrowers and those who value low rates over flexibility benefit most from closed mortgages.
How can I avoid prepayment penalties on my closed mortgage in Canada?
To mitigate penalties, stay within annual prepayment allowances, wait until maturity, or choose a variable rate or short-term closed mortgage.
How to find the best closed mortgage rate in Canada?
Shop mortgage rates from banks, brokers, credit unions, etc. Get pre-approved with a broker who can find you the lowest rate.
What are closed mortgage penalty fees in Canada?
The penalty for breaking a closed mortgage early is typically three months' interest. Prepaying above the annual limit also incurs penalties.
How do I switch to a different closed mortgage lender in Canada?
You'll need to pay any penalty fees to your existing lender first. Get pre-approved before your term ends for a smooth transition.
What are the benefits of closed mortgages in Canada?
Closed mortgages offer lower interest rates, fixed payments, and rate protection than open mortgages in Canada.
How do closed mortgages work in Canada?
Closed mortgages provide a single lump sum at the outset that is repaid on a set schedule. Once repaid, the original principal cannot be reused or extended.