Paying off an open mortgage early is certainly possible. But what about a closed mortgage contract? Is it possible to exit from a closed mortgage contract early? The answer is YES!
But paying it off early is a little bit trickier than you might have hoped. Be it an open or closed mortgage, paying early in both cases tags along with some costs.
In the case of a closed mortgage, the prepayment penalty, breakage costs, and other charges could be higher–sometimes to the extent that paying off early becomes a costly affair. Therefore, a thorough calculation before deciding to end a closed mortgage contract is a must! Visit this site to know the differences between an open and closed mortgage.
Table of Contents
- What Is A Closed Mortgage?
- Costs Involved In Paying Off A Closed Mortgage Early
- Pros And Cons Of Breaking A Closed Mortgage Contract
- How To Reduce Or Avoid Prepayment Penalties?
What Is A Closed Mortgage?
A closed mortgage, also known as a closed-end mortgage, is a limiting mortgage that prohibits borrowers from paying off, renegotiating, or refinancing the mortgage early. Specific prepayment penalties, breakage costs, and other charges are involved in renegotiating or paying off the mortgage early.
A closed mortgage is preferred over an open-end mortgage due to lower interest rates. But it limits the borrower’s ability to use the house’s equity as collateral to refinance before its term ends.
Generally, you should opt for a closed mortgage if:
- You have a long-term vision
- You’re not going to move or sell early
- You’re searching for attractive interest rates
Pros Of A Closed Mortgage
- It offers lower interest rates to homebuyers.
- Borrowers have the assurance that the interest rates will not vary till the end of the term.
- It offers substantial time to repay the amount.
- It adds a sense of security to people with fixed, regular incomes.
Cons Of A Closed Mortgage
- It limits homebuyers to pay off, negotiate, and refinance the mortgage before the term ends.
- Repayment penalties, breakage costs, and other charges make it too costly.
- It is challenging to refinance a closed mortgage.
- It is a less flexible model.
Reasons To Break A Closed Mortgage Contract
Several factors influence a homebuyer to pay off a closed mortgage early. The most popular driving factors are:
- A homebuyer wants to sell the home before the mortgage term ends.
- Market stability and growth have cut down the interest rates.
- A borrower’s income has increased, so they want to pay off the mortgage early.
- Refinancing to find a better rate.
- Fulfilling the purpose of buying the home.
- Moving out of the property for some reason.
Costs Involved In Paying Off A Closed Mortgage Early
Deviating from the closed mortgage contract could impose a prepayment penalty, charge, or breakage cost. The lender will charge a prepayment penalty if a borrower:
- Wants to pay more than what is in agreement.
- Opts to break a closed mortgage contract.
- Transfers the mortgage to another lender.
- Wants to renegotiate the terms of the contract.
If not planned or in case of an uncalculated decision, a borrower may end up paying more on breaking the close mortgage contract than they’d have otherwise paid on abiding by the contract.
To safeguard the interests of borrowers, an option called prepayment privilege is available. Prepayment privilege is a powerful tool that eliminates prepayment penalties for breaking a closed mortgage contract. It offers:
- Flexibility to increase the regular payments up to a certain limit
- Make lump-sum payments of up to a certain percentage
Calculation Of Prepayment Penalties
The calculation of prepayment penalties depends upon several factors like repayment amount, remaining term, and lender. Most established lenders, financial institutions, and banks provide a prepayment penalty calculator on their official websites.
Generally, lenders charge a penalty equal to three months of interest on the remaining mortgage amount or the interest rate differential (IRD), whichever is higher. They calculate IRD when:
- The current mortgage rate is lower than your current mortgage interest rate.
- Your mortgage is not older than five years.
Example Of Prepayment Penalty Calculation
Let’s assume the outstanding amount is $200,000 and the current interest rate is 6 percent. So, the prepayment penalty will be three months’ interest.
200,000 x 0.06 = 12,000
12,000 / 12 = 1,000
So, 1,000 x 3 = $3,000 will be the prepayment penalty.
Note that the IRD calculation comes into effect if 36 months are left from the entire term of five years.
Suppose the current interest rate is 4 percent. Here, the difference between rates becomes 2 percent.
$200,000 x 0.02 = $4,000
Next, divide the term left with 12:
36/12 = 3.
Finally, $4,000 x 3= $12,000 will be the prepayment penalty as per the IRD method.
Lenders will charge $12,000 since it’s the highest of the two figures.
Pros And Cons Of Breaking A Closed Mortgage Contract
Generally, a borrower will break a closed mortgage contract if he comes across a better interest rate. Therefore, it’s advisable to weigh its pros and cons before going through with it.
- Better mortgage rate with an extended-term.
- You get peace of mind if you pay off the mortgage early.
- Homeowners can use their house’s equipment to refinance their other needs.
- You get an option to renegotiate the mortgage rate and term.
- The idea of paying off early or renegotiating is to put off the burden and save the remaining interest. But the hidden charges and prepayment penalty associated with breaking the contract could cost you more in the long run.
- There’s a possibility that a homebuyer fails to secure a new mortgage or refinance under stringent new economic conditions.
How To Reduce Or Avoid Prepayment Penalties?
The first step should be to understand the terms and conditions of the contract before inking it. Some useful tips to avoid prepayment penalties are:
- Include the prepayment privilege option in the contract.
- Utilize the prepayment privilege option fully to repay the mortgage amount early–this helps reduce the mortgage amount significantly. Keep in mind that lenders calculate a prepayment penalty on the remaining balance.
- You can port your mortgage or blend and extend the mortgage to avoid prepayment penalties.
- Wait till the term ends to reduce the prepayment penalty.
Always calculate the potential costs associated with breaking a closed mortgage contract. If ignored, you end up paying more in the form of prepayment penalties and other charges. Lenders are advised to research, compare, and seek expert advice before signing or breaking a closed mortgage contract.