Open vs closed mortgages in Canada, explained

How open and closed mortgages differ

An open mortgage can be paid off in full at any time, for any reason, with no prepayment charge. A closed mortgage can only be paid off early if you pay a penalty. On a variable, that's 3 months of interest. On a fixed, it's the greater of 3 months of interest and the interest-rate differential. In exchange, a closed mortgage has a noticeably lower rate, often more than a full percentage point lower.

Almost everyone should take a closed mortgage, and the large majority of Canadian mortgages are closed. The more useful question is what prepayment privileges come with the closed mortgage. That's where you'll find most of the flexibility people want from an open term.

What an open mortgage costs

An open mortgage is priced well above a closed one with the same term. The lender can't count on holding the loan for any length of time, so it has to fund it differently.

Here's what that premium buys. On a $400,000 mortgage, a 1-point rate premium is roughly $4,000 a year in extra interest. The penalty you'd avoid on a closed variable-rate mortgage is 3 months of interest, about $4,200 on the same balance.

So an open variable mortgage costs you roughly the whole penalty you were avoiding, every year, whether you ever break it or not. If you're sure you'll pay the mortgage off within a few months, that can still be the right trade. Over a year, it rarely is. Over 5 years, it almost never is.

The comparison with a fixed-rate penalty is closer, because an interest-rate differential based on the posted rate can be very large. Usually, though, the better answer is a lender that calculates its IRD against the discounted rate. Paying an open-mortgage premium for 5 years costs more.

Prepayment privileges on a closed mortgage

Every closed mortgage in Canada comes with prepayment privileges. Read them before you sign.

Typical privileges:

• A lump sum of 10% to 20% of the original principal per year. Depending on the lender, you may pay it on the anniversary, on any regular payment date, or in several instalments.
• A payment increase of 10% to 20%, which you can use once or more per year, and which is sometimes reversible.
• A double-up option, which lets you make an extra payment equal to your regular one.
• Switching to an accelerated payment frequency, which gets the least attention and has the biggest effect.

On a $400,000 mortgage, a 20% annual lump sum privilege is $80,000 a year. That's more prepayment room than almost any household will use. In practice, a closed mortgage with good privileges is flexible. You just can't pay it off in full without a penalty.

Switching from monthly to accelerated bi-weekly payments is one of the most effective things most borrowers can do, and it costs nothing. You make the equivalent of 13 monthly payments a year instead of 12. On a typical 25-year mortgage, that takes roughly 3 years off the amortization.

When an open mortgage makes sense

An open mortgage is the right choice in a few situations, and they share one thing: a short, known timeline.

• You're selling within months. The property is already listed, or you have a confirmed move date. Paying a premium for 3 months costs less than an interest-rate differential.
• An estate or a property in transition. You don't control the timeline, and the mortgage needs to go when the property does.
• Bridging between 2 properties. A bridge loan built for this is usually the better option, though.
• A large, certain payment coming soon. A settlement, a maturing investment, or the proceeds of another sale.
• A file that needs a year to season. You're coming off an alternative or private mortgage and expect to qualify with an A lender soon. Even here, a 1-year closed term is often cheaper than open.

The test is how certain you are about the date. "We might move in a couple of years" isn't the same as "we take possession of the new place in March." Only the second one justifies the premium.

Watch out for no-frills mortgages

This is the opposite problem to paying for an open mortgage, and it costs people far more.

Some of the lower rates on any rate board, including the ones we publish, belong to no-frills or restricted products. The rate is lower. What's been taken out to get there varies, and that's what you need to check:

• A bona fide sale clause. The only way out of the mortgage before maturity is an arm's-length sale of the property. You can't refinance out, you can't switch lenders early, and there's no penalty you can pay to leave.
• No portability, so moving means breaking the mortgage.
• Few or no prepayment privileges.
• A restricted refinance, which sends you back to the same lender at whatever rate it offers.

If you'll hold the mortgage to maturity and never change it, a restricted product at a lower rate is a sensible choice, and we'll place you in one. If you might need to change it, that 0.05% saving can become very expensive, because no penalty payment gets you out.

The same rule applies to open vs closed: pay for flexibility in proportion to how likely you are to use it. Roughly 6 in 10 Canadian mortgages are broken or significantly changed before a 5-year term ends. Very few of those borrowers expected to be in that group when they signed.