What Is a Closed-End Mortgage?
A closed-end mortgage (also known as a "closed mortgage") is a restrictive type of mortgage that cannot be prepaid, renegotiated, or refinanced without paying breakage costs to the lender.
This type of mortgage makes sense for homebuyers who are not planning to move anytime soon and will accept a longer term commitment in exchange for a lower interest rate. Closed-end mortgages also prohibit pledging collateral that has already been pledged to another party.
These may be contrasted with open-end mortgages.
- A closed-end mortgage features several restrictions that borrowers are subject to.
- Limitations may include no prepayment, or forbidding the use of home equity as collateral for an additional mortgage or line of credit.
- Closed-end mortgages are typically less risky for lenders, but may pose challenges to some borrowers.
- If these restrictions are violated, the borrower will be required to pay penalty fees.
Understanding Closed-End Mortgages
A closed-end mortgage can have a fixed or variable interest rate, but carries with it several restrictions and limitations for the borrower. Under the terms of a closed-end mortgage, for instance, the borrower could not use the equity they have invested in the home as collateral for additional financing. So, if a borrower is 15 years into a 30-year closed-end mortgage and has paid off half of their debt, they cannot take out a home equity loan or other form of financing without the original lender’s permission along with paying the breakage fee. Additionally, the borrower of a closed-end mortgage will face penalties if they pre-pay mortgage principal.
An open mortgage, on the other hand, can be repaid early but will have a higher interest rate, while a convertible mortgage blends characteristics of closed and open mortgages.
Lenders may offer closed-end mortgages as a way to mitigate risk when granting financing to the borrower. Should the borrower default on the mortgage, or enter into bankruptcy proceedings, by having a closed-end mortgage, the lender can be assured that there will be no other lenders who can claim the house as collateral. In exchange, the lender offering the closed-end mortgage might structure the agreement to grant the borrower lower interest rates.
If a homeowner is able to take out a home equity loan; for example, if their primary mortgage is open-ended, the new financing could classify as a closed-end second mortgage. Unlike a home equity line of credit (HELOC), this type of financing could not be expanded upon to allow the borrower to take even more money out against the home.
The terms of closed-end mortgages raised some concerns that homebuyers might not know the full extent of what they were agreeing to. The restrictions of this type of financing limit the ways borrower might structure their finances while they are lured in by the potential for extremely low interest rates on the mortgage. This does mean, however, that they cannot pay off the loan sooner, which would allow them to save some money instead of paying the ongoing interest for the full life of the mortgage.