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Closed versus open mortgages

For the uninitiated, choosing the right mortgage can feel like a trip through a labyrinth blindfolded. There are so many different types of mortgages available, it's hard to know where to start and what's best for you.

One of the first things you should decide is whether you want an open or a closed mortgage.

An open mortgage is one in which the borrower can repay the loan, in full or in part, any time prior to maturity without penalty. The terms are generally short and range between six months and one year.

"If you think you might win a lottery, or you have the capacity to earn more money, it's a perfect solution," says Ruby Cortes, a lending specialist with VanCity Credit Union in Vancouver.

A closed mortgage, on the other hand, can't be paid out fully, renegotiated or refinanced before maturity without paying the lender a compensation penalty. The term for a closed mortgage can range anywhere from six months to 10 years. Interest rates may or may not be lower on closed mortgages than open ones, depending on the economic climate.

Penalty costs can be steep
Beware: The costs associated with closed mortgages can be high. Know the payout penalties before you agree to one. Generally speaking, the penalty depends on how far along you are in the life of your mortgage. It's usually a three-month interest payment or the Interest Rate Differential (IRD), whichever is more.

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The IRD is the difference between the contractual rate of the mortgage and the rate the lender can now get for its money. For example, a mortgage with a three-year term remaining at 6 percent can offer the lender a market rate of only 4 percent. The borrower must pay the difference in interest.

"Most banks will waive the penalties if you replace the mortgage with one where the rate, the amount or the amortization period is the same or higher," says Cortes.

Of course, there are risks -- either psychological or financial -- associated with both types of mortgages. A closed mortgage offers the borrower peace of mind: The rate is fixed over a term that works within long-term goals. The borrower knows exactly how much he pays toward the principal and interest and does not have to worry about unexpected rate hikes that can lead to soaring monthly payments.

Conversely (and here is why people tend to shy away from closed mortgages), should interest rates decrease drastically, the borrower fails to benefit.

Keep an eye on interest rates
The advantages of both open fixed-rate and variable-rate mortgages is that the borrower can pay out the mortgage in full at any time without incurring penalties. A York University study conducted in 2001 in conjunction with Manulife Financial found that people who chose short-term, variable-rate mortgages saved an average of $22,000 in interest costs per $100,000. That's a new bathroom or a dream vacation!

If you've calculated the risks and decided that an open mortgage suits your needs, you should keep a close eye on interest rates. This makes a decision on whether and when to switch to a fixed-rate mortgage from a panic attack to an educated guess. To keep up to date on where rates are headed, check out Bankrate's Mortgage Home Page. It's possible to predict interest rates to a degree, but remember, it is an art, not a science, and you could be wrong.

If you see signs that rates are about to go up, consider locking into a mortgage and avoid the trap of no longer being able to afford payments on your home.

First-time buyers who plan to live in their home for a long time probably benefit the most from closed mortgages. Real estate investors who want guaranteed interest rates and payments for a specified amount of time should also opt for closed, says Lou Guerrero, a mortgage broker with Vancouver's Home Loans Canada.

Open mortgages work for consumers who plan to sell their home in the near future because they won't have to pay a penalty when the home is sold.

The same applies to consumers who believe interest rates are falling or who expect to receive a large sum of money in the near future. (In that case, they can pay out their loan without penalty.) This is an important consideration for many boomers who stand to receive comfortable inheritances in the next decade.

Determine your goals for the future
So how do you decide which mortgage suits you? Guerrero says you should map out your goals for the next five years: Do you plan to start a family? Do you foresee a promotion or pay increase at work? How long do you plan to stay in your home?

"Everyone's situation is different," says Cortes. "If they can take the risk, we'll talk about an open mortgage. It's all about risk."

Ultimately, whether you choose an open or closed mortgage depends on which stage of life you're at, your income, your goals and the amount of risk you are willing to take. There are advantages and disadvantages to each, so use the resources available to you to make the right choice.

Pam Withers is a business journalist, business-book editor and author of a best-selling teen novel.

-- Posted: Sept. 20, 2004
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