Open versus closed
An open mortgage allows you to repay the mortgage - in part or in full - at any time during the term without any penalties or repayment costs.
Open mortgages are usually available in shorter terms - six months or a year - and the interest rate is higher than closed mortgages. They provide flexibility until you are ready to lock into a closed term. These types of mortgages are ideal for those who are thinking of selling their home, or if they're expecting to pay off the whole mortgage from the sale of another property or from an inheritance.
A closed mortgage must remain unchanged for the term. The interest rates are considerably lower than open mortgages and if you're not planning to sell your home, or expecting any boosts in income, a closed mortgage could be the right fit. Lenders allow you to pay down a lump sum of 20% of the original principal annually. If you wanted to pay more than the allotted amount, or pay the mortgage off in its entirety, you would incur a penalty of about three months' interest.
Most mortgages have a prepayment privilege, says Siegle, and that will vary from lender to lender or product to product. Some mortgages being offered in the marketplace right now have pretty attractive interest rates, but they don't have very flexible prepayment privileges. Others have three options to prepay your mortgage - you can pay 25% of the original balance as a lump sum, you can increase your payments by 25% and you can even double up your payments on top of that. Some offer three different ways you can prepay your mortgage without any penalty, but they're available at a higher rate, he says.
The most common fee incurred by buyers is when you attempt to put down more money on your loan than you're allotted. Paying a lump sum of money annually is called an annual prepayment or a principal payment option or privilege. Some banks allow customers to pay down 10% to 20% of the principal amount per year, says Kuo.
There is quite a variance between how certain lenders calculate those prepayment penalties. Some charge an interest rate differential of three months' interest. But it's important that you ask questions, says Dal Bianco. Any mortgage documentation that you sign will tell you what penalties you could incur, and your lawyer should take you through the document and the potential penalties or fees. Expert legal advice can never go astray when dealing with matters as long-term as these.
Fixed versus variable
A fixed rate is an interest rate that does not change throughout the course of your mortgage term. With the same interest rate, you have a regular interest payment and you know the exact amount your payments will be each month. This can make personal budgeting easier. Having a fixed rate makes it possible for you to figure out how much of your mortgage you will have paid off by the end of the year.
"Some people like fixed rate because if they fix the rate for three years, they know exactly what their mortgage payment will be for three years, and in three years' time their interest rate will not have changed. It gives them peace of mind," says Kuo.
A variable rate is an interest rate that fluctuates with the market during your mortgage period. They provide a lot of flexibility and are especially appealing when interest rates are on their way down. Although your mortgage payment typically remains constant, the ratio between your principal and interest rate fluctuates. If interest rates go down, more money goes toward repaying your principal, helping you pay off your mortgage faster. If interest rates go up, you pay more interest and less principal. If they rise substantially, the original payment may not cover both the interest and the principal. The portion that is not paid is owed, and you could be asked by your lender to increase your monthly payment.
It's a good idea to make sure your variable-rate mortgage is open or convertible to a fixed-rate mortgage so that when rates begin to rise, you can lock-in your rate for a specific term, says Siegle.
However, the onus to do so is on the customer. Some customers follow interest rates closely and will call their lender to switch from variable to fixed, but many customers do not. And if you're not following interest rates regularly, you may miss out on opportunities to save money.
Currently, most first-time buyers are choosing fixed rates, says Siegle, adding a few years ago it was common for first-time buyers to choose variable rates. As of late February 2009, a five-year variable mortgage could be had at about 3.8% to 4% and a five-year fixed mortgage at about 4.4%, so the fixed is only a little higher, says Siegle. But given the current challenging economic climate, more people prefer the stability of fixed mortgages, he adds.
The premium of half a point is justified with the peace of mind borrowers get from having a fixed rate. Historically, a 4.4% fixed-rate mortgage doesn't happen very often, so perhaps this is as good as it gets or as close as it gets in terms of fixed-rate mortgages.
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