LINGO

Variable & Fixed, Closed & Open: Some Basic Mortgage Jargon Explained

I have a lot of mortgage conversations over the course of a week. And during those conversations I realize that many folks don’t have some basic mortgage lingo correct. Time for me to do my job!

The biggest culprits are the terms Fixed, Variable, Closed and Open. When a new client tells me they want a “five-year, variable-fixed mortgage,” I suspect they’re either confused or have been misled when it comes to the jargon.

In short: “Variable” and “Fixed” are types of mortgage rates. “Closed” and “Open” describe how a mortgage can be paid off.

A Variable-rate mortgage is exactly that: the rate is set at (a discount or premium to) a lender’s Prime interest rate. In turn, the lender’s Prime rate fluctuates – 8 times per year. As Prime fluctuates, so does the rate (and almost always, the payment) on a Variable-rate mortgage over its term. Variable mortgages are currently available in three or five-year terms with most lenders, with the five-year term being the most popular. Variable mortgages provide you with the option to convert into a fixed-rate mortgage, which I’ll describe below. The other form of a Variable rate home loan is a Home Equity Line of Credit (HELOC). HELOCs have no term per se and in most cases, their monthly payments are comprised of interest only.

A Fixed-rate mortgage is also exactly what it sounds like. The rate is set at the start, and it’s fixed for the entirety of the term. Neither the rate, nor the mortgage payment, changes until the term is over. Most all lenders currently offer Fixed terms of 1, 2, 3, 4, 5, 7, and 10 years; and again, the five-year Fixed is the most popular.

The vast majority of mortgages in Canada are Closed. That is to say, they are Closed from full repayment…unless you’re willing to pay a penalty to break (think, switch or refinance) or pay off (think, sell your home) a mortgage before the end of its current term.

Most all lenders offer “prepayment privileges,” which are features that allow you to partially pay down your otherwise Closed mortgage faster than just making the originally set payments. You can increase the frequency of your payments (for example, making 26 bi-weekly payments per year will chip things down faster than 24 semi-monthly payments). You can increase the amount of that payment, regardless of its frequency: for example, some lenders will allow you to double up. Finally, you can also make lump-sum payments: some lenders will allow you to pay down your mortgage in chunks, by as much as 20% of its original amount each year. Different lenders will offer more or better pre-payment privileges than others. Your mortgage broker can lay out options for you to compare.

Otherwise, paying down or paying off a Closed mortgage any faster than its privileges allow, will result in you paying a penalty. In almost all cases, breaking a Closed Variable mortgage before its term is over will result in a penalty of three months’ interest on the remaining balance, at the prevailing rate. Breaking a Closed Fixed mortgage mid-term will generally result in the levying of a penalty called an Interest Rate Differential, or IRD. This complicated term is even more complicated to calculate or explain, and it actually varies by lender.

All you need to know today is that by and large, the IRD for breaking a Closed Fixed mortgage is significantly higher than the three months’ interest payable in breaking a Closed Variable mortgage. In simple math, I’ve seen Closed Fixed IRD’s that are anywhere from 4.5 to 22 times the size of a Closed Variable penalty, depending on the circumstances.

Why is this? Think of it this way: in one sense, you’re being “rewarded” for having incurred the relative uncertainty of a Closed Variable mortgage and its fluctuating rate/payment, in the form of a (much) more modest penalty. Flip-side, you’re being penalized (and sometimes very heavily) for walking out of what was supposed to be a certain and long-term relationship in a Closed Fixed mortgage.

Open mortgages are much easier to explain. Quite simply, they are “Open” for partial or total repayment – anytime, and with NO penalty. That’s whether the mortgage is Variable or Fixed. Your HELOC is actually an Open Variable product; you can pay the interest only, or if cash flow allows, you can pay down a huge chunk with no repercussions. If you Google the posted interest rates for your favourite bank, you’ll see that the rates they offer for actual, Open mortgages are significantly higher than their Closed counterparts. This is simply to compensate the lender for the likelihood (inevitability) that you’ll be breaking that Open mortgage.

Open mortgages look like a rip-off, but they can be timely. Take advantage of them when you know a change is imminent at the end of your current mortgage term: the most common instances are when the sale or refinancing of your home is around the corner. On a related note, most all private mortgages are Open because they are generally used for a short-term problem or opportunity. Private lenders are compensated for offering Open (and very fast/flexible) short-term mortgages through higher rates and upfront fees.

A period of higher interest in an Open mortgage can be peanuts compared to the penalty incurred in breaking that Closed mortgage with an alluringly lower rate. Leave it to your mortgage broker to present you with the math for your circumstance.

So that’s it! Variable, or Fixed. Closed, or Open. Hope this helps to clear things up.