What Is a Closed End Mortgage?
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A closed-end mortgage, or closed mortgage, is a means of financing a home with substantial restrictions. The restrictiveness of the mortgage, which can result in paying penalties if certain understandings are breached, is usually offset with a lower interest rate. Before you consider this mode of financing or enter into an agreement, make sure you understand what a closed end mortgage is all about.
What are the restrictions with a closed end mortgage?
With a closed end mortgage, a homeowner cannot refinance or renegotiate the mortgage. This also means the borrower cannot gain additional financing using the equity invested into the home as collateral. So, if a borrower took a closed end, 30-year mortgage and wanted to refinance for lower monthly payments using the equity in the home as collateral, this is not permitted. There is, however, a way to break a closed end mortgage with the consent of the lender by paying a penalty called a breakage fee.
The other chief restriction with a closed end mortgage is how the borrower cannot pre-pay on the principal of the loan. This means that a homeowner is not permitted to pay the mortgage off early. If the borrower tries to do so, then a prepayment penalty is incurred to help offset the interest income lost by the lender.
Are there any advantages to a closed mortgage to buyers?
There is one big advantage for a buyer having a closed end mortgage. The interest rate is incredibly low. As the interest rate is usually fixed in a closed mortgage, the rate will not increase for the life of the loan. The other potential advantage of this type of mortgage to buyers is that it may be easier to gain approval if the borrower’s credit is less than stellar. This is due to the decreased risk to the lender with a closed end mortgage than an open or convertible one.
What are the advantages and disadvantages to lenders?
A closed end mortgage is far more advantageous to lenders than borrowers, as the restrictiveness of the terms work in a lender’s favor. From a financial standpoint, the lender knows exactly how much will be gained in interest income since there is no prepayment without significant penalty.
In the event of a foreclosure due to borrower nonpayment, the lender does not have to worry about any other entity placing a claim on the property. This is because a closed end mortgage does not permit the use of home equity as collateral for additional financing. If the borrower doesn’t pay, the lender gets the house, which can be resold to recoup any losses.
As there are essentially no disadvantages to the lender, this type of mortgage is frequently the first kind offered to a potential borrower. In the event of the borrower having lower credit, a closed end mortgage may be the only option offered to finance a home. After all, the lender takes on little to no risk.
If you’re researching a means to finance a new home purchase, consider an open- or convertible-style mortgage over a closed end mortgage.
While an open mortgage carries a higher interest rate, it can be paid early. This is a good option for borrowers who feel their finances may improve and could pay off the loan in part or full in a shorter time frame. A convertible mortgage starts as an open mortgage but can later be switched to a closed mortgage for a lower interest rate. This offers buyers some flexibility when future financial standing is less known.