Open mortgage
Mortgages that contain a clause allowing a lump-sum of
money to be prepaid in addition to the regular monthly
payment are said to have "open" privileges. To many
people, "open" is synonymous with the right to prepay a
mortgage. Unfortunately, there is a lot of confusion over
the concept of "open," because different degrees of
"openness" exist from lender to lender, and different lenders
have different "open" privileges.
Just because a mortgage is "open" does not necessarily mean it is "fully
open." ("Fully open" means the entire amount can be prepaid at any time without
notice, bonus or penalty.) Anyone shopping for a mortgage, either to finance a
purchase or to refinance an existing loan, must learn not only whether a
mortgage is open but also to what extent it's open. The time to ask about a
lender's open features is right at the outset, before the mortgage is booked.
Five different categories of lump-sum prepayment
clauses appear in mortgage documents. Variations within
and between each category distinguish different lenders'
prepayment packages. Making life even more difficult for
borrowers is the fact that some mortgages fit into one
category for part of the term and another for the balance.
And remember, since these are contractual prepayment
clauses, they must appear right in the mortgage document.
Starting with what's best for borrowers, mortgages can be:
- Fully Open: No Notice or Penalty -The whole
principal, or any part of it, can be prepaid at any time
without any prior notice to the lender and without paying any
penalty or bonus interest. But there is a downside: the
term
and the rate. Fully open mortgages are only available for
very short terms -six months or a year. And borrowers
pay a premium of one-half percent or more for this type of
privilege, compared to a closed mortgage with the same
term. Many vendor-take-back mortgages are structured as
fully open, although some do contain an interest penalty. Mortgages from private
lenders may be fully open, too, but with restrictions.
- Open with a Fixed Penalty or Notice -It's
similar to "No Notice or Penalty", as all or part of it can be prepaid at any
time, making it open. But it's not "fully" open, since a predetermined penalty,
clearly stated in the mortgage, must be paid when prepaying the mortgage.
(Occasionally the clause says a certain amount of notice will be accepted in
lieu of the penalty.) The penalty doesn't have to be negotiated when the
prepayment is made; that was done when the mortgage was booked. Usually, the
penalty charged is three months' interest on the amount prepaid, though it could
be more or less, or it could be based on a formula. Remember: the cost to break the mortgage is
pre-arranged when the mortgage is booked; it does not
depend on any lender's discretion when the prepayment is made.
- Limited (Partially) Open: No Penalty or
Notice on that Portion - This type of mortgage is open only to a limited extent. A
gratuitous clause in the mortgage allows borrowers to
prepay up to 10% or 15% annually, without any notice or
penalty on the amount prepaid. But the clause applies just
to that limited portion of the mortgage. In other words, just because a mortgage
has limited prepayment privileges does not make it fully open; being 10% or 15%
open annually while being silent on the rest means the remainder of the mortgage
is closed, not allowing any prepayment before maturity.
While the open portion can be prepaid penalty-free, a
penalty must be paid when the closed portion of the
mortgage is prepaid. And the penalty isn't predetermined. Instead, the penalty for prepaying the closed
portion must be negotiated when the prepayment is made.
Since lenders don't have to accept an early repayment of
the closed part of the mortgage, they have the absolute
discretion to decide whether it can be prepaid or
renegotiated before maturity, and if so, what penalty the borrower
must pay to break the contract. So while the mortgage
contract says no penalty will be charged on the first 10% or
15% prepaid (the open portion of the mortgage), the
penalty charged on the remaining 90% or 85% (the closed
portion) can be as arbitrary and unreasonable as the lender
wants, just as with any other closed mortgage.
- Limited (Partially) Open: Fixed Penalty or
Notice on that Portion -This is a hybrid of
categories "Open with a fixed penalty or notice" and "Limited (partially) open:
No penalty or notice on that portion". As in the third category, a limited (10% or
15% annually) open prepayment privilege exists, while the
rest of the mortgage is closed. As in the second category, a
predetermined penalty must be paid (or a fixed amount of
notice given by the borrower) to utilize that limited
prepayment privilege. Again, the lender can charge any
penalty it wants when the closed part of the mortgage is
prepaid; or it can refuse to permit the prepayment
altogether, at its discretion.
- Fully Closed
NOTE: All mortgages, of whatever category, are fully open on their maturity.
All or
part of the outstanding principal can be paid when the
mortgage comes due, with no prepayment penalty whatsoever.
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