Think Twice Before Taking a 5-Year Closed Mortgage

The internet is full of debates about whether to take a mortgage interest rate that is fixed or variable.  However, what gets less attention is whether the mortgage is open or closed.  The most common fixed-rate mortgages are closed, and this means you’d have to pay a penalty if you break your mortgage.

I can already hear most people saying “but I’m not going to break my mortgage, so I don’t have to worry about penalties.”  However, the future can surprise us.  If breaking a mortgage cost us a finger, we’d think a lot more carefully about what might happen to make us break our mortgage: job loss, job moves to another city, divorce, health problems, bad neighbours, and more.

Mortgage penalties aren’t as bad as losing a finger, but they can be bad enough.  Suppose you took out a 5-year mortgage at TD Bank 2 years ago, and it has a remaining balance of $300,000.  According to Ratehub’s mortgage penalty calculator, the cost to break your mortgage would be $16,463!

Lenders deserve some compensation if you break a closed mortgage, but a penalty this big far exceeds any reasonable compensation.  The way they justify it is to do the calculations based on “posted rates,” which are much higher than the interest rates people typically pay.  The gap between the posted rate and the real rate is highest for 5 year mortgages, and gets smaller for shorter mortgages.  This declining gap size is what pumps up the mortgage penalty calculation.

So, when you’re trying to decide whether you’ll come out ahead with a fixed or variable rate mortgage, think carefully about what might happen that would force you to break your mortgage.  A mortgage penalty can easily be larger than the cost difference between fixed and variable interest rates.