What is an open-end mortgage? Overview, benefits, examples
Open-end mortgages are loans that allow borrowers to return to the lender and request an increase to the original loaned amount. For the right borrower, these products can provide a cost-effective and flexible financing solution.
What makes open-end mortgages unique? And are there any downsides?
Keep reading to learn everything you need to know about this financing option, including a breakdown of its benefits, drawbacks, and unique characteristics.
What is an open-end mortgage?
An open-end mortgage is a type of mortgage that gives the borrower the ability to increase the original amount borrowed.
The increase in loan value—up to a predefined amount—can occur even after initial funding. This is in contrast to a closed-end mortgage, where the loan amount is fixed from the outset.
Put another way: open-end mortgages allow borrowers to borrow money against the equity in their property, repay it, then, if desired, borrow again at their discretion.
The benefits of open-end mortgages:
- Flexible: Open-end mortgages allow funds to be drawn only as needed. This makes the product particularly beneficial for ongoing expenses or sudden projects.
- Interest only on the used portion: You only pay interest on the amount you’ve borrowed, not the total amount you’ve been approved for. This can mean lower interest payments when compared to a traditional lump-sum loan.
- Potential tax implications: In some jurisdictions, interest paid on open-end mortgages may be eligible for tax deductions.
- Cost-effective: For short-term needs, like repairing a leaky roof, open-end mortgages can be a more cost-effective solution than taking out a large loan all at once.
- Safety net: Although not its primary intended purpose, open-end mortgages can provide you with easily accessible cash when emergencies arise.
- Competitive interest rates: The interest rate on open-end mortgages is typically lower than that on unsecured credit products, like most credit cards. This is because the product is secured against an asset: your home.
- Control: Open-end mortgages provide borrowers control over when and how much money they access.
Angelika bought her dream home in Upstate New York about ten years ago for $250,000. Since then, she’s been diligently paying off the loan each month.
Now, she only owes $100,000 on the original mortgage. Not only that, the home has doubled in price over the decade and is currently valued at $500,000.
Angelika wants to renovate her kitchen and help her son pay for college, so she decides to apply for an open-end mortgage. Following the application process, her bank approves Angelika for a loan with a $100,000 limit.
Two months later, she uses $50,000 from the available $100k loan to pay for her son’s first two years of college. As a result, the bank begins charging her interest only on this amount.
Six months after taking out the money for tuition, Angelika once again taps into the loan, drawing another $30,000 to pay a contractor to renovate her kitchen. She now owes $80,000 on the loan and still has $20,000 if needed.
Over the next three years, Angelika pays only the interest component of the open-end mortgage loan amount.
By now, her house is worth $600k and she decides to sell. The $600k sales prices allows her to easily clear her original $100k mortgage balance and the $80k of additional principal she owes on the open-end loan.
After everything is settled, Angelika walks away with $420,000.
How does an open-end mortgage work?
The product works similarly to revolving credit, like credit cards. With revolving credit, you have no fixed payments. Instead, payments are based on the actual amount borrowed and the corresponding interest costs associated with the loan.
Borrowers of open-end mortgages are given a maximum principal amount that they can access (borrow) over a specific period.
This is similar to how an issuer would provide you with a maximum limit on your credit card. You use what you need and are only charged interest on that portion.
- Equity estimate: First, your home's equity is calculated. Equity is the difference between the present market value of your house and the outstanding amount you owe on any existing mortgages. For example, if your home is currently valued at $500k and you owe $200k on your current mortgage, your equity is $300k ($500k less $200k).
- Application: As with all loans, you’ll need to apply for an open-end mortgage with a bank or other type of lender. This entails filing out application forms, undergoing a credit check, and potentially providing proof of income.
- Appraisal: To confirm your equity, the lender will typically complete a current property appraisal. This tells the lender how much they can safely lend you.
- Limit: Based on an assessment of your creditworthiness, income, and the current value of your property, the lender will establish a credit limit. This is the maximum amount you can borrow.
- Accessing funds: Following approval, access will be provided to loan proceeds. Unlike a traditional loan, you won’t be given a lump sum. Instead, you’ll provided access to an account from which you can draw funds only as needed.
- Repayment: Usually, open-end mortgages include what’s known as a "draw period." During this time—usually a few years—you might be permitted to make interest-only payments. Once the draw period is complete, only then will you begin repaying both the principal and interest.
- Reborrowing: Should you choose to, you can reborrow funds that have previously been repaid.
- Closing the loan: Usually, after 10 to 20 years, an open-end mortgage will fully mature, meaning you can no longer draw funds and must begin repaying the entire balance, assuming you haven’t already.
- Settlement: Once repayment is complete, the open-end mortgage is considered "settled." If you fail to make the required payments, the lender could foreclose on your property.
How to get the most out of an open-end mortgage
- Understand the terms and conditions: Before signing any loan, it’s imperative to thoroughly read and understand the terms and conditions of the loan. For example, is the interest variable or fixed, are there any additional fees, are there particular restrictions around repayment, etc?
- Budget wisely: Treat open-end mortgages like any other loan. Tap into the funds only when needed, and avoid using it for non-essential items. Ultimately, you’ll have to pay it back… with interest.
- Emergency reserve: Gaining access to an open-end mortgage today can help you if you run into trouble in the future, like needing cash for an emergency medical procedure.
- Regularly check rates: If you sign up for an open-end mortgage with a variable rate, keep an eye on the market. Rate changes can quickly increase the cost of your loan.
- Pay more than the minimum: When possible, pay more than the minimum amount required. This will help reduce the principal faster and save you money over the life of the loan.
- Avoid maxing out: To help keep your credit healthy, avoid taking the full amount of the loan out.
- Reinvest in your home: By using the open-end mortgage proceeds to upgrade your home, you can contribute to improving and increasing the value of your asset.
- Leverage tax benefits: Consult with a tax professional to confirm what local tax deductions are available. For example, in some places, using the proceeds for home renovations allows you to claim the tax on the interest portion of the loan.