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 or other penalties 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 places several restrictions on the borrower in exchange for a lower interest rate.
- Limitations may include prepayment penalties, or forbidding borrowers from using home equity to secure an additional mortgage or line of credit.
- If these restrictions are violated, the borrower will be required to pay penalties.
- Closed-end mortgages are typically less risky for lenders.
Understanding Closed-End Mortgages
A closed-end mortgage can have a fixed or variable interest rate, but carries with it several restrictions for the borrower. For example, closed-end mortgages restrict the borrower from using the home equity they have built as collateral for additional financing. So, if a borrower is 15 years into a 30-year closed-end mortgage and has repaid half their debt, they cannot take out a home equity loan or other form of financing without the original lender's permission and paying the breakage fee. Additionally, the borrower of a closed-end mortgage will face a prepayment penalty if they pay their mortgage principal early.
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, by having a closed-end mortgage, the lender can be assured 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 be classified as a closed-end second mortgage. Unlike a home equity line of credit, this type of financing cannot be expanded to allow the borrower to take out even more money against the home.
Homebuyers who are considering a closed-end mortgage should fully review the terms and understand the full extent of the conditions. While the lower interest rates on the mortgage may be attractive, the trade-off is that borrowers will be limited in how they structure their finances. For example, a borrower who wants to pay off their loan early to save on interest charges will instead be faced with a penalty or stuck paying the ongoing interest for the full life of the mortgage.