Mortgage Types Explained
If you’re just getting into the mortgage game, there are a ton of options available to you. You might see on the news that some bank just lowered its 5-year variable-rate mortgage to 2.99%, but does that mean it’s your best option?
Let’s take a look at some of the options so you’ll know in a broad sense what is available.
Open, Closed, And Convertible Mortgages
Closed Mortgage – Called closed because they are for a set period of time and for a set interest rate. If you want to pay off your mortgage before that period is finished, you’ll likely pay a pretty large penalty. The upside is a very low interest rate. Banks offer lower rates on closed mortgages because they’re very predictable (ex. 3% for 5 years).
Open Mortgage – Like an open marriage (NOT an endorsement), an open mortgage gives you a lot of flexibility – make lump-sum payments or pay off the entire mortgage early. Because they’re open and thus less predictable (much like an open marriage!), you’ll generally pay slightly higher interest rates than on a closed mortgage. You may also have to deal with rising interest rates. If you’re expecting a huge windfall of cash in the time between when you purchase and when your mortgage term expires that you’d want to use to pay off your home, you might opt for an open mortgage. Remember as well that many closed mortgages offer generous lump-sum payment options, and there’s a good chance taking advantages of those will give you all the accelerated pre-payment flexibility you need.
Convertible Mortgages – These, as the name suggests, let you change the type of mortgage you have. If, for example, you started the mortgage and after two years you believe interest rates are going to go up, you might opt to lock into a longer term to benefit from this.
Fixed And Variable Rates
Fixed Rate – Fixed, as in set, locked in. A fixed rate mortgage is one where the interest rate will stay the same for a certain amount of time. So when you see 5-year fixed-rate mortgage for 3.5%, you know that you’ll pay that 3.5% interest for 5 years and there’s no way it can go up (or down).
People like fixed rate mortgages because they are predictable. You’ll know for the life of your mortgage exactly what your payment will be, as well as how long it will take to finish paying off your house.
Variable Rate – Variable, as the name suggests, changes. When you hear on the news that interest rates have gone up or down, you’ll know your mortgage interest rate probably changed as well.
If you think rates will go down, opting for a variable rate is a good strategy. Historically, variable rate mortgages end up being cheaper in a given 5-year period than fixed rate mortgages. The drawback is that if interest rates DO go up, the portion of each payment that goes to interest will go up, while the portion that goes to actually paying off your home will go down. That means every time interest rates go up, it will take longer to pay off your home – AND it will cost more.
Lastly, variable rate mortgages generally offer a lower starting interest rate than fixed rate ones. For example, a current 5-year fixed rate interest rate might be 2.77% while a 5-year variable interest rate will be 2.5%. You’ll have to decide how quickly interest rates will go up and which one makes more sense for your current situation.
Now you should understand a lot of the mortgage terms that get tossed around. Always ask for details from your financial institution or mortgage lender, as everyone has different policies when it comes to all of these options.