The Pros and Cons of Closed, Open, and Partially Open Terms
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February 15, 2023 |
The Pros and Cons of Closed, Open, and Partially Open Terms
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As a mortgage professional, you need to provide various mortgage products to meet your clients' diverse needs in a competitive industry. Nowadays, many borrowers are unable to qualify for traditional mortgages, leading them to explore alternative lending options. While there are many reasons why someone may need alternative lending, this post will focus on helping you advise your clients on the best alternative term to choose. If you're interested in learning more about alternative lending scenarios, we recommend checking out this CMP article entitled "When is alt-lending the right solution for clients?" as a helpful resource.
The private alternative market offers a plethora of term lengths and types, which can be overwhelming to navigate. It's kind of like scrolling through Netflix, where the abundance of choices can lead to analysis paralysis. To avoid this, it's important to fully understand your client's problem or goal and determine how long it will take to resolve or achieve it.
When brokers come to me with a deal, one of the first questions I ask is how long the client needs the mortgage and how realistic that timeline is. This helps me understand the broker's game plan and advise the broker on which option will likely have the lowest cost based on their timeline.
The statement "interest rate isn't everything" is especially true in the world of alternative lending, as costs associated with the selected loan term, such as lender fees and charges, can significantly increase the cost of borrowing.
Tradeoffs
Let's explore the cost tradeoff between closed, open, and partially open terms as an example:
Closed Term: This option typically offers the lowest interest rate, but borrowers face a prepayment penalty of three months' interest if they want to pay off the loan early.
Open Term: This option has no prepayment penalty, but there is often a lender fee. For instance, Neighbourhood charges a 1% lender fee on Open Terms.
Partially Open Term: This option borrowers can pay off the loan early without penalty after a certain period of time. Historically, Neighbourhood’s partially open term has been closed for the first three months and the rate has trended higher than its’ closed and open counterpart.
Different Scenarios
Let’s see how this works in three different scenarios using a fictitious rate of 12% for both closed and open terms and a loan amount of $100,000 to reduce complexity. Additionally, we have limited transaction costs to interest, lender fees, and prepayment penalties.
Scenario 1: Loan paid out at the beginning of the year (January) - e.g. the loan is paid off immediately.
| Closed Term | Open Term | Partially Open Term | |
|---|---|---|---|
| Loan Amount | $100,000 | $100,000 | $100,000 |
| Interest Rate | 12% | 12% | 12.75% |
| Lender Fee | $0 | $1,000=$100,000 * 1% | $0 |
| Prepayment Penalty | $3,000=$100,000 * (12% * 3/12) | $0 | $0 |
| Interest due | $3,187.50=$100,000 * (12.75% * 3/12) - Since the loan is paid out at the beginning of the year and the loan is closed for the first three months, they owe three months of interest. | ||
| Total interest, fee, and penalty cost | $3,000 | $1,000 | $3,187.50 |
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Closed Term:
Loan Amount = $100,000
Interest Rate = 12%
Lender Fee = $0
Prepayment Penalty = $3,000 ($100,000 * (12% * 3/12))
Total interest, fee, and penalty cost = $3,000
Open Term:
Loan Amount = $100,000
Interest Rate = 12%
Lender Fee = $1,000 ($100,000 * 1%)
Prepayment Penalty = $0
Total interest, fee, and penalty cost = $1,000
Partially Open Term:
Loan Amount = $100,000
Interest Rate = 12.75%
Lender Fee = $0
Prepayment Penalty = $0
Interest due = $3,187.50 ($100,000 * (12.75% * 3/12)) - Since the loan is paid out at the beginning of the year and the loan is closed for the first three months, they owe three months of interest.
Total interest, fee, and penalty cost = $3,187.50
Scenario 2: Loan paid out in the middle of the year (June) on the sixth payment date
| Closed Term | Open Term | Partially Open Term | |
|---|---|---|---|
| Loan Amount | $100,000 | $100,000 | $100,000 |
| Interest Rate | 12% | 12% | 12.75% |
| Lender Fee | $0 | 1% or $1,000=$100,000 * 1% | $0 |
| Interest paid over term | $6,000=$100,000 * (12% * 6/12) | $6,000=$100,000 * (12% * 6/12) | $6,375=$100,000 * (12.75% * 6/12) |
| Prepayment Penalty | $3,000=$100,000 * (12% * 3/12) | $0 | $0 |
| Interest due | $0This is because the term is now open on regular payment dates. | ||
| Total interest, fee, and penalty cost | $9,000=$6,000+$3,000 | $7,000 | $6,375 |
-
Closed Term:
Loan Amount = $ 100,000
Interest Rate = 12%
Lender Fee = $0
Interest paid over term: $6,000 ($100,000 * (12% * 6/12))
Prepayment Penalty = $3,000 ($100,000 * (12% * 3/12))
Total interest, fee, and penalty cost = $9,000 ($6,000 + $3,000)
Open Term:
Loan Amount = $100,000
Interest Rate = 12%
Lender Fee = 1% or $1,000 ($100,000 * 1%)
Interest paid over term: $6,000 ($100,000 * (12% * 6/12))
Prepayment Penalty = $0
Total interest, fee, and penalty cost = $7,000
Partially Open Term:
Loan Amount = $100,000
Interest Rate = 12.75%
Lender Fee = $0
Interest paid over term: $6,375 ($100,000 * (12.75% * 6/12))
Prepayment Penalty = $0
Interest due = $0 - this is because the term is now open on regular payment dates
Total interest, fee, and penalty cost = $6,375
Scenario 3: Loan paid out at the end of the year (December) on maturity
| Closed Term | Open Term | Partially Open Term | |
|---|---|---|---|
| Loan Amount | $100,000 | $100,000 | $100,000 |
| Interest Rate | 12% | 12% | 12.75% |
| Lender Fee | $0 | 1% or $1,000=$100,000 * 1% | $0 |
| Interest paid over term | $12,000=$100,000 * (12% * 12/12) | $12,000=$100,000 * (12% * 12/12) | $12,750=$100,000 * (12.75% * 12/12) |
| Prepayment Penalty | $0 | $0 | $0 |
| Interest due | $0 | ||
| Total interest, fee, and penalty cost | $12,000 | $13,000=$10,000 + $12,0000 | $12,750 |
-
Closed Term:
Loan Amount = $100,000
Interest Rate = 12%
Lender Fee = $0
Interest paid over term: $12,000 ($100,000 * (12% * 12/12))
Prepayment Penalty = $0
Total interest, fee, and penalty cost = $12,000
Open Term:
Loan Amount = $100,000
Interest Rate = 12%
Lender Fee = 1% or $1,000 ($100,000 * 1%)
Interest paid over term: $12,000 (100,000 * (12% * 12/12))
Prepayment Penalty = $0
Total interest, fee, and penalty cost = $13,000 ($1,000 + $12,000)
Partially Open Term:
Loan Amount = $100,000
Interest Rate = 12.75%
Lender Fee = $0
Interest paid over term: $12,750 ($100,000 * (12.75% * 12/12))
Prepayment Penalty = $0
Interest due = $0
Total interest, fee, and penalty cost = $12,750
I’ve graphed this scenario to help you better visualize the cost. As you can see in the graph:
The Closed Term is the most expensive if the borrower pays out the loan before month eleven;
The Open Term is the least expensive option until month two; and
The Partially Open Term is the least expensive from month two onward.
Key Takeaways: Understanding The Pros and Cons of Closed, Open, and Partially Open Terms
It’s important to note that the results will change based on each option's interest rate, lender fee, and prepayment penalty.
Here is a general overview of the features, benefits, and drawbacks of Closed Term, Open Term, and Partially Open Term. Remember that the interest rate, lender fee, and prepayment penalty will affect each option's overall cost of borrowing, so you will likely need to do some calculations yourself.
The Closed Term product can be a great option for clients who are looking for a low rate and are comfortable committing to a full year with the lender. It's important to keep in mind that this product comes with a prepayment penalty if the client decides to pay out their mortgage early. This makes it best suited for clients who are confident they won't need to pay out their mortgage during the term, or for those who may not be able to pay out their mortgage early due to certain financial circumstances. For example, borrowers with lower credit scores may find it more challenging to graduate to an A or B lender, and may therefore need to commit to a Closed Term product.
On the other hand, the Open Term is ideal for clients who want the freedom to pay out their mortgage quickly without incurring any penalties. However, the rate plus fee is likely to be higher than the total rate of the Closed Term, so it's best suited for clients who will be paying out the loan early. For example, we have seen the Open Term utilized by brokers whose clients wish to sell their existing property and need equity in their existing home to bridge the purchase of a new home. Another use case is where a borrower needs alternative financing to close on a presale and intends to sell it immediately after. This example is a relatively common scenario given how long some projects take to complete and changes in the borrower's financial circumstance during the property's development.
The Partially Open Term, also known as the Closed Then Open Term, allows clients to pay out their mortgage without penalty on select payment dates, but at a higher rate than the Closed Term. This product is ideal for clients who anticipate needing to pay out the loan midterm, but may require a bit more time to do so. For instance, a borrower who wants to purchase a new property before selling their existing home may choose the Partially Open Term to make improvements to their current home in the hopes of selling it for more.
It's important to note that the scenarios and information provided in this post are simplified examples and are for educational purposes only and not indicative of Neighbourhood’s current rates or pricing.
The interest rates, lender fees, prepayment penalties, and other costs can vary depending on the lender and the specific mortgage product, so it’s important to do your research and due diligence before recommending a lender to a client. We put together a blog post to help you with your alternative lender due diligence, which you can read here.
As a mortgage professional, it's important to thoroughly understand the various mortgage products available to your clients, including the alternative mortgage terms of Closed, Open, and Partially Open. Each option offers distinct benefits and features, but it's crucial to consider factors such as the interest rate, lender fees, and prepayment penalties to determine the overall cost of borrowing. Additionally, by understanding the borrower's funding needs and goals and analyzing how long they will need funds, you can assist them in selecting the most suitable alternative mortgage term. By carefully evaluating these factors, you can help your clients make an informed decision that best meets their requirements.
Author Profile
Jared Stanley is the Senior Director of Originations at Neighbourhood Holdings. He has been in the industry for nearly 15 years. In 2015, Jared was awarded Underwriter of the Year by the Canadian Association of Accredited Mortgage Professionals. He is also a motorcyclist and dog lover.