An open-ended mortgage works like a traditional mortgage but allows the borrower to obtain additional cash later during the term for additional expenses. These additional expenses are typically home improvements and renovations, which can cost a lot. These mortgages are a good option if the borrower doesn’t want to utilize the whole mortgage amount once and use some cash later as needed. For example, a borrower can purchase a portion of the loan to purchase a property and leave other portions for future use. I will use examples in this post to explain how these mortgages work and whether they are a good option for the borrower or not.
What Is an Open-End Mortgage?
An open-end mortgage allows the borrower to obtain the highest loan amount that they can qualify for. This amount can be obtained even if the borrower doesn’t need it all to purchase a home. Once the borrower has purchased the home, the unused portion of the loan remains. The borrower can use this unused portion later during the draw period for home improvement and renovations.
One of the best features of using this type of mortgage is that the lenders don’t charge interest on the unused loan. The borrower only has to pay interest for the amount they have borrowed. An open-ended mortgage is a good option if the borrower wants to obtain additional funds for the house, and instead of getting a separate loan, they can attach it to the current mortgage. This type of mortgage is difficult to qualify for and is not available in all states.
How Do Open-Ended Mortgages Work?
An open-end mortgage agreement permits a borrower to take an additional amount before repaying the current mortgage. The borrower can obtain more funds after taking permission from the mortgage lender. These types of mortgages work similarly to a line of credit, and their application process is the same as other mortgages.
The borrower makes principal and interest payments just like a conventional mortgage. However, if the borrower decides to take an additional amount, they must also make payments on the new amount. The borrower has to pay both payments monthly because the lender is the same for both mortgages.
An open-ended mortgage works according to the two main principles of a mortgage, which are the draw period and the repayment period.
The draw period is the time of the mortgage term during which the borrower can draw funds as needed in an open-end mortgage. This is a fixed period during which the borrower can draw additional funds upon request and permission from the lender. The funds are available during the withdrawal period only. The ‘draw period’ features work similarly to a line of credit. This period also varies from lender to lender; for example, some lenders will allow the borrowers to draw any time for up to 5 initial years, while others will allow drawing cash for up to 10 years.
The repayment period is when the borrower has to repay the loan. Mortgages usually require 10 to 30 years to mature, depending on the repayment plan. The repayment period begins with the loan commencement date and continues till the lender has agreed for the mortgage to mature. The details of the repayment period are included in the loan commitment.
Open-Ended vs. Close-Ended Mortgages
The borrowers can choose either open-ended or closed-ended mortgages. The main difference between these two mortgages is the debt repayment. A closed-end mortgage can’t be refinanced or renegotiated until the whole mortgage has been paid off. According to this deal, the borrower can’t take any additional amount during the term once they have already obtained a lump sum. Examples of closed-end mortgages include auto, personal, and student loans.
On the other hand, an open-end mortgage allows the borrowers to draw additional funds after obtaining one lump-sum amount. The open-end mortgages can also be repaid early, unlike closed-end mortgages. The borrower can pay off the mortgage at an earlier time without any penalty or extra charge. The borrower can draw funds during the ‘draw period’ with an open-end mortgage. Some lenders also allow the borrowers to renew the line of credit after the draw period has ended. However, if the lender doesn’t allow the credit line renewal, the borrower must repay the outstanding balance in full. Remember that an open-end or closed-end mortgage can’t be converted into another mortgage once the agreement has been made.
Benefits of Open-End Mortgages
The following are the benefits of open-end mortgages:
- Borrowers can draw funds from the loan amount as needed
- A maximum amount of credit to meet various expenses
- No payment of closing costs for two different loans
- Usually no prepayment penalties
- Borrowers may pay only interest on the borrowed amount
Drawbacks of Open-End Mortgages
The following are the drawbacks of closed-end mortgages:
- Interest-rate and fees are high
- Frequent use may lead to unnecessary withdrawal of funds
- Missed payments may affect the credit score
- Huge debt and minimum payments can be a financial burden
Open-End Mortgage Examples
Example 1: Suppose Joseph wants to buy a home worth $275,000. Since Joseph is a responsible borrower and has made previous payments on time, his credit history is good. Thus, he manages to get a mortgage of $400,000 from an open-ended mortgage. The mortgage is a 30-years fixed mortgage at a rate of 6.25%. This is a good option for him as he plans to live in the house permanently or at least until his children are all grown up.
However, to buy the home, he needs only $275,000; thus, he takes a lump sum of only $275,000 and starts paying monthly payments at a rate of 6.25%. However, after ten years, he needed funds to renovate his garage. Joseph returns to his lender and requests an additional $40,000 from the lender. This amount is now added to the outstanding mortgage, and the balance has increased. Joseph will now make monthly payments at the same rate but according to the new due balance.
Example 2: Suppose Rachel is approved for an open-ended mortgage of $250,000 and bought a home for $180,000. Since she took only $180,000 from the lender, she has to pay the principal amount based on this outstanding balance at a rate of 5.75% for 30 years. The following is the breakdown of this open-ended mortgage:
- Mortgage approved: $250,000
- Home Price: $180,000
- Outstanding mortgage: $180,000
- Term: 30 years
- Interest rate: 5.75%
- Monthly payments: $1,235
- The total cost of the loan: $378,413
Now Rachel has to cover the total cost of the loan for obtaining $180,000 only. After ten years, Rachel has paid a $149,000 mortgage and still has an outstanding balance. Now, she wants to renovate her TV lounge and borrows an additional $35,000 from the same lender. Due to this extra amount, the mortgage balance increases. The following are the details after obtaining additional funds:
- New mortgage: $35,000
- Term: 20 years
- Interest rate: 5.75%
- Monthly payments: $334
- The total cost of the loan: $59,127
- Total monthly payment of two loans: $1,235 + $334 = $1,569
Now Rachel has to pay the total monthly payments of two loans, one for the previous loan and one for the new loan she took for renovation. She has now taken $215,000 out of her approved $250,000 loan amount. She can still take an additional loan of $35,000 to meet any other expenses in the future.
Frequently Asked Questions
What are the Alternatives to an Open-Ended Mortgage?
Open-ended mortgages are difficult to find; if the borrower can’t find a lender, they can consider alternatives. The borrower can get the same benefits as open-ended mortgages if they purchase a home through a traditional mortgage and then apply for a home equity line of credit (HELOC). However, with this process, the borrower will have to apply for two mortgages and deal with two sets of closing costs. Besides that, other home loans include FHA, VA, and USDA loans.
What are the Requirements for an Open-End Mortgage?
The application process of an open-end mortgage and a conventional mortgage are similar. However, the requirements vary from lender to lender. The following are the main requirements for an open-ended mortgage:
- Most lenders require a credit score of at least 660, but some may also ask for a score of 680 or 700
- A debt-to-income ratio of 43% or less
- A loan-to-value ratio of 80% or less
Borrowers who meet these requirements are most likely to be approved for an open-ended mortgage easily.
Is an Open-End Mortgage Worth It?
An open-end mortgage is suitable if the borrower wants to purchase a home and thinks they might need an additional amount later. If the borrower has qualified for a mortgage larger than they need for purchasing a home, they can consider getting an open-end mortgage. However, if the borrower doesn’t intend to use additional funds in the future, it is useless to get an open-end mortgage.
Is an Open-End Mortgage Better Than a Closed-End Mortgage?
Both types of mortgages have their pros and cons. The following table will help you choose between an open-end and closed-end mortgage:
|Line of credit
|Allows early repayment without penalty
|Early payment comes with a penalty
What to Know for the Real Estate Exam
An open-end mortgage is a mortgage that allows borrowers to draw funds at any time during the term. After obtaining a lump sum amount at the start, the borrower can draw additional funds later at any stage as needed. However, the borrower can only draw funds from an agreed loan amount at loan commencement. The amount that the borrower takes at the start as a lump sum doesn’t cover the whole loan, and some amount is left for later use.
Open-end mortgages are very flexible as they allow borrowers to meet any unexpected expenses in the future. However, the borrower must remember that the lender uses the property as collateral, and if the borrower fails to repay the loan, the lender can seize the property. Go through more Real Estate Vocabulary and learn more about the terms needed to prepare for your real estate exam.