You have probably heard about home loans, also commonly known as mortgages. They help you buy a home for yourself after which you can pay back the loan.
There are many types of mortgages. But the one we are curious about is an open end mortgage.
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What is an Open End Mortgage?
With an open end mortgage, you can borrow additional money at a later date on a loan you already had. An open end mortgage is a mix of some qualities of a traditional mortgage and some features of a home equity line of credit, also known as HELOC.
With an open end mortgage, you can turn the value of your home equity into cash by increasing the loan balance you originally had. You are permitted to go back to the lender and borrow more money, although, there might be a set dollar limit on how much you can borrow.
How an Open End Mortgage Works?
An open end mortgage has many similarities with a delayed draw term loan. It is also similar to the features of revolving credit. However, open end mortgages tend to be unique because of the fact that this loan agreement is secured against a real estate property and the funds are only going towards the investment for that same property.
The process to apply for an open end mortgage is the same as the process of application for other credit products. The terms of the loan are determined by what the borrower’s credit score looks like. Co-borrowers can also have a higher chance of getting approved if they present a low default risk.
With open end mortgages, borrowers have a maximum principal amount that is obtained over a specified time. The borrower can choose to take a portion of the loan value that they have been already approved for in order to cover the costs of their home. This way, the borrower will have to pay low interest since interest payments can only be made on the outstanding balance.
The time specified at which the borrower can receive the loan principal is specified in the terms of an open end mortgage loan. However, the amount that can be borrowed may also be connected to the value of the home.
Open end mortgages can be different from delayed draw term loans because the borrower is not supposed to meet any specific requirements set in order to obtain additional funds. An open end mortgage is also different from revolving credit since the funds in an open end mortgage are typically only available for a specified time. Whereas, according to the terms of revolving credit, the funds are supposed to stay open indefinitely with the only exception being if the borrower defaults. So what is an example of an open ended revolving loan? An open end credit loan that can be borrowed multiple times is a pre-approved loan granted by a financial institution such as credit cards.
The drawdowns from any available credit can only be used against the secured collateral in an open end mortgage. Which is why it is important for payouts to go toward the real estate property that is under the lender’s name.
Let’s take an open end mortgage example:
Suppose a borrower got $200,000 from an open end mortgage to buy a home. The mortgage has the term length of 30 years with a fixed interest rate of 5.75%. The borrower receives rights to the open end mortgage principal amount but they are not required to take the full amount at one. The borrower can then choose to take $100,000. This would require interest payments to be made at the rate of 5.75% on the outstanding balance.
Fast forward to six years later when the borrowers took out an additional $50,000. The additional amount is also added to the principal amount and the borrower is now required to pay the 5.75% interest on the total outstanding balance.
Advantages of an Open End Mortgage
One of the biggest plus points in an open end mortgage is the flexibility. The borrower can choose to take out as much cash out of home equity as much is needed.
Furthermore, it is easier to take out cash from equity through an open end mortgage than it is by getting a home equity loan, HELOC or opt for cash-out refinancing. Whereas with an open end mortgage, you can have the freedom of requesting more funds without having to re-qualify or even pay closing costs that you would have to pay with a second loan.
Moreover, with an open end mortgage, the interest is only paid on the amount you have drawn. For instance, taking out an open end mortgage for an amount of $200,000 where you use only $100,000, you would only have to pay interest on the $100,000.
If you later decide to borrow an additional $100,000, you would have to start paying principal and interest on the combined amount. So you would be paying for the additional $100,000 as well as the initial loan balance of $100,000 minus the amount you have already paid in the interim.
Another advantage of an open end mortgage is that there is no penalty for paying off the mortgage before the due date comes whereas traditional mortgages tend to have a fee for early payment.
Once you borrow money using the open end mortgage deed and pay it back on time, you can borrow even more money if you want. This can continue for as long as the borrowing period stays open. However, you should note that the total amount you borrow should not exceed the property value.
Disadvantages of an Open End Mortgage
An open end mortgage a future advance clause will typically have a higher interest rate than a traditional mortgage would have. The interest rate on the amount you initially borrow may be fixed. However, if you borrow any additional amount, the interest rate may vary with market conditions. So it is possible that you end up borrowing at a higher interest rate than you borrowed on before.
Open end mortgages only have an allowed period where you can borrow the money you want that is known as the “draw period.” So once the draw period ends, the borrower will not be able to take out any more cash out of equity. Whereas a HELOC does not have any set limitations about when the additional money can be borrowed.
Another drawback of an open end mortgage is that your home is the only collateral. You can end up losing it if you do not pay back the loan on time. Which means you would not have a place to live anymore.
Lastly, the total amount that is borrowed, including the initial amount and any additional draws, will not normally exceed the value of the home. However, this can end up becoming an issue for you if your home declines.
Open End Mortgage vs. Closed End Mortgage
We know what an open end mortgage is. But how different is it from a closed end mortgage?
A closed end mortgage has strict rules and restrictions for its borrowers. However, it can have either a fixed or variable rate. It cannot be prepaid, renegotiated or refinanced without paying the breakage costs to the lender.
Whereas an open end mortgage can be repaid early but will have a higher interest rate.
There is also the option of a convertible mortgage that blends the features of an open end and closed end mortgage together to create an infusion to make a product that will cater to people who cannot find a balance between open end and closed end mortgages.
So now you are well aware of what is an open end mortgage. People often tend to use open end mortgages if they foresee a need to borrow against home equity at a later date in order to pay for any upcoming expenses they might have.
However, it might be too risky for you to try and pay for vacations and other discretionary expenses since you are putting your home up as collateral in order to secure them in an open end mortgage.
However, an open end mortgage can be a good idea if you have the ability to purchase the home without needing to borrow the entire amount that is the purchase price but will probably feel the need to borrow again sometime in the future. A good credit history and financial strength will only help you in acquiring a home without borrowing the amount of the entire purchase price. In situations like such, open end mortgages can prove to be a good alternative for home equity loans and other forms of financing that can help you get a home for yourself.