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The Differences Between Open and Closed & Variable and Fixed Rate Mortgages
If you’re new to buying property, all the different terms and rules are likely to have your head spinning in confusion. You’re dealing with the biggest purchase you’re ever likely to make so choosing a mortgage shouldn’t be taken lightly after all, but the key to choosing is in understanding what the differences are and how they will affect you. Do you choose the open mortgage or the closed mortgage, the variable rate or the fixed rate?
Open and Closed Mortgages
When you’re applying for a mortgage, many lenders will give you the option as to whether you want an open mortgage or a closed mortgage. Open mortgages are becoming more and more popular, though you may still find that not all lenders offer this type of mortgage.
So what is the difference between open and closed mortgages? Well with an open mortgage you get far more flexibility. It’s ‘open’, kind of like a bank account, allowing you to make extra payments to your mortgage whenever you want to. For example, if you often receive bonus pay in your wages and you want to put that money into paying off your mortgage, an open mortgage would be the one for you.
Open mortgages also give you the flexibility to pay them off whenever you choose to, without penalty, though if you are closing the mortgage account altogether, or transferring to another lender, there will usually be a small fee to do this.
The drawback for this flexibility is that the interest rate is usually higher for an open mortgage because the lender has slightly more risk – they don’t know when you’ll be adding money to the pot so to speak, making it more difficult for them to forecast and invest.
Closed mortgages have traditionally been the more common, and are still preferred by many homeowners who know exactly what their incomings and outgoings are going to be every month. The benefit of closed mortgages is that the interest rate will normally be a little lower than for open mortgages because it’s a more stable environment for your lender and less risky, however, if you want to pay off your closed mortgage before the term is up you will have a penalty to pay. If you move home you would usually be paying off your current mortgage and getting a new one, but if you stay with your current lender, you may be able to avoid having a penalty.
The other consideration when comparing open and closed mortgages is that a closed mortgage isn’t entirely as it sounds! Many lenders nowadays will happily allow you to pay in up to an additional 20% of your original principle balance every year, so even with a closed account your mortgage can be paid off a little quicker.
Variable Rate and Fixed Rate Mortgages
The other big consideration when choosing mortgage is do you go for a variable rate or a fixed rate mortgage? If we all had crystal balls and could see into the future, answering this question would be so much easier! But unfortunately no-one really knows what the future holds so it’s always a little hit and miss when making this decision.
Fixed rate Mortgages
A fixed rate mortgage is exactly as it sounds; fixed at the rate that you agree on, for the specified time period, and no matter what happens with the bank prime rate, your interest rate will be unaffected. Of course if the prime rate was to go down while you have a fixed rate mortgage you may end up losing out a little, but if it goes up you’ve done well as you’re protected from a rate increase.
Variable Rate Mortgages
A variable rate mortgage changes in tune with the bank prime rate, going up or down as the prime does, but it’s important to remember that this is the interest rate we’re talking about changing, not your monthly payments. So your actual monthly payments shouldn’t vary unless they’re not enough to cover the interest payments.
Another consideration is that some lenders will allow you to change from a variable rate mortgage to a fixed rate mortgage at any time during your term, without any penalties. It’s worth finding out if your lender would allow this because you could potentially change from a variable rate if it looked as though the bank prime rate was going to increase.
Deciding on a Term
The first thing to bear in mind when considering a variable rate or fixed rate mortgage is your term. When you apply for a mortgage you will look at the different interest rates and make a decision as to how long you want your initial term to be. This could be from 6 months to sometimes as much as ten years, depending on the lender, and the length of term you choose will probably determine whether you go variable or fixed rate, as the interest rate will vary accordingly.
If you know you’re going to be staying put in your new home for some years, and you’re sure your circumstances won’t change, it may be worthwhile choosing a longer initial term and this will protect you against big rate increases. However, the longer the term, the higher the interest rate becomes because it’s more risky for the lender. Really the safest bet would be to go for something in the middle, say three years, as this will give you a decent interest rate, and if you decide to move home or mortgage lender you can do so after only three years without penalty.