Closed vs. Convertible Mortgage: What's the Difference?
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When buying a home, you face a lot of big decisions. Some of them are more fun than others (walk-closets, anyone?), but all of your decisions should be made with research and care. One of the most important decisions you’ll make is the type of loan you choose to take out.
Fortunately, you have a wide selection of mortgage types to choose from. When you begin your research, you’ll discover that two of the most common mortgages are closed and convertible mortgages. But, what are they, how are they distinct, and—most importantly— how will they impact your monthly payments?
Here’s what you need to know about closed and convertible mortgages.
What is a closed mortgage?
A closed mortgage, also known as a closed-ended mortgage, is a type of mortgage that you can’t prepay, renegotiate, or refinance without having to pay a penalty. This type of fixed rate mortgage is designed for homebuyers looking to settle down and remain in the same location for a long period of time.
- In exchange for a lower interest rate, this loan type places certain restrictions on the borrower. For the most part, a closed mortgage contains the following provisions:
- Borrowers face penalties for paying off the loan early.
- Borrowers are often restricted from using the equity in the home for an additional mortgage.
- A restriction is placed on the borrower from using the home’s equity to secure a line of credit.
- A penalty payment is required for violating any of the loan’s restrictions.
Closed mortgages pose a low amount of risk to the lender. The number of penalties for paying off a loan early vary according to the lending company. In many cases, this penalty amount can be up to 80% or six months’ worth of interest.
That means, if the homeowner’s financial situation changes and they are suddenly able to repay their loan in full, the penalty costs might be too high to make it worth paying off early. However, in some cases, such as when the interest you would pay over the duration of the mortgage is less than the pre-pay penalty, it’s worth it to pay the loan off earlier or refinance it into a different type of loan.
What is a convertible mortgage?
A convertible mortgage, unlike a closed mortgage, starts off with an adjustable rate. This variable rate can change as the housing market ebbs and flows along with various financial indexes around the world. In the U.S., this is the Treasury Constant Maturities Index, which is used as a reference point when determining the interest rate for an adjustable rate mortgage (ARM).
The best part of a convertible mortgage is that you can convert it to a fixed rate mortgage at a later date. You can also get a convertible mortgage that is the other way around, starting out with a fixed rate that you can convert into an adjustable rate later in your mortgage term.
The only caveat of this type of mortgage is that there is a time period for which the mortgage must be kept as an ARM or a fixed rate mortgage.
Which one is best?
So, which is best, a closed or convertible mortgage? A lot depends on your situation. If you plan on owning a home for a long period of time and want a lower interest rate, then a closed mortgage may be the right choice for you. On the other hand, if house prices are high when you decide to buy, you could opt for a convertible ARM mortgage if you think interest rates might drop at some point in the future.