Closed-end Mortgage

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.

Understanding Closed-end Mortgages

A closed-end mortgage can have a fixed or variable interest rate, but it carries 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 of 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.

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 that no other lenders 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.

Open-end vs. Closed-end Mortgages

Closed-end mortgages can be contrasted with open-end mortgages.

A closed-end mortgage generally cannot be renegotiated, repaid, or refinanced until the entire mortgage has been paid off—or at least not without paying a significant fee. But closed-end mortgages also typically have lower interest rates because lenders regard them as a lower risk.

An open-end mortgage, on the other hand, can be repaid early. Payments generally can be made anytime, and this means that borrowers can pay off their mortgage much more quickly and at no extra charge. However, open-end mortgages also normally have a higher interest rate.

There are also other types of mortgages, called convertible mortgages, which try to provide the best of both worlds by blending characteristics of closed-end and open-end mortgages.

Pros and Cons of a Closed-end Mortgage

The primary advantage of a closed-end mortgage is its lower interest rate. Lenders will generally offer their very lowest interest rates on closed-end mortgages, and borrowers can be assured that this rate won’t change for the duration of the mortgage.

This makes closed-end mortgages a great choice if you plan to have your mortgage for a long time and don’t mind paying it back slowly and steadily—or if you simply prefer the security of knowing that your mortgage payments will stay the same for the entire length of your mortgage.

The disadvantage of a closed-end mortgage is that you lose flexibility with this model. If you inherit a significant sum of money and have a closed-end mortgage, and you want to use the money to pay it off more quickly, you won’t be able to do so.

Similarly, open-end mortgages can be better for people whose careers are still developing quickly, because this arrangement allows them to tailor their repayments to their income, rather than to an agreed sum. Because of this, open-end mortgages can help you to pay off your mortgage faster, albeit at a higher interest rate.

Other Considerations

If a homeowner is able to take out a home equity loan—for example, if their primary mortgage is open-end—then the new financing could be classified as a closed-end second mortgage. Unlike a home equity line of credit (HELOC), 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 tradeoff 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.