Why It Matters
Closed-mortgage mechanics appear whenever you sign an agency loan, a CMBS deal, or — in Canada — virtually any standard residential mortgage. The rate savings look attractive upfront, but selling or refinancing early triggers a prepayment penalty that can reach five figures or more on an investment-grade balance. The closed-versus-open decision deserves real math before you sign.
At a Glance
- What it is: A mortgage that restricts early payoff or refinance until maturity, in exchange for a lower interest rate
- Primary penalty types: IRD (Interest Rate Differential) or 3-month interest — whichever is larger
- IRD trigger: Applies when current rates are lower than your contract rate; can be several percent of principal
- Where it shows up in the US: Agency loans (Fannie/Freddie multifamily), CMBS lockout periods, yield maintenance provisions
- Where it dominates: Canada — the 5-year fixed closed mortgage is the standard residential product
- Trade-off: Lower rate now versus flexibility to exit or refinance without penalty later
How It Works
The rate-for-flexibility trade-off. A lender offering a closed mortgage typically funds it by borrowing at a fixed rate in the bond market. If you prepay, they still owe bondholders — so the prepayment penalty makes them whole on the lost spread. Two penalty structures apply. The IRD (Interest Rate Differential) is: (Contract Rate − Current Rate) × Remaining Principal × Remaining Term in years. On a $480,000 balance at 5.75% with three years left, if rates have dropped to 3.75%, the IRD is (0.02) × $480,000 × 3 = $28,800. The floor — three months of simple interest — would be (5.75% ÷ 4) × $480,000 = $6,900. The lender charges whichever is higher. That gap can swing dramatically based on how far rates have moved since origination.
US equivalents: yield maintenance and CMBS lockouts. US investors financing stabilized multifamily through Fannie Mae, Freddie Mac, or FHA don't use the term "closed mortgage," but they operate under identical economics. Agency loans include a yield maintenance clause that compensates the lender for lost yield on early payoff — the math closely mirrors IRD. CMBS loans go further: a hard lockout window of two to five years prohibits prepayment entirely, followed by a defeasance or yield maintenance period. During defeasance, you substitute Treasury securities to keep the lender's cash flow intact rather than paying cash. For a $3 million CMBS loan in year three of a ten-year term, defeasance can exceed $200,000 depending on Treasury rates.
When the closed structure makes sense — and when it doesn't. Long-hold investors on stabilized assets almost always come out ahead with a closed loan. A 0.75% rate reduction on a $500,000 balance saves roughly $3,750 per year — $18,750 over five years — while the penalty only hits if you exit early. The math reverses if you plan to refinance within two to three years, run a value-add flip, or hold a property where a forced mid-term sale is plausible. The open-rate premium is a known, budgetable cost. The IRD penalty lands as a surprise at the worst moment — when you're already under pressure to close.
Real-World Example
Marcus closes on a 12-unit in Raleigh for $1.47 million using an agency loan at 5.25% — the closed structure knocked 0.60% off the open rate, saving roughly $8,800 annually. Two years later, a buyer makes an unsolicited offer projecting a 22% IRR for Marcus if he accepts. He runs the yield maintenance math: remaining balance $1.41 million, remaining term 8 years, spread between his 5.25% note and today's comparable Treasury of 3.45% = 1.8 points. Penalty: 0.018 × $1,410,000 × 8 = $203,040. The deal still clears — but Marcus has to reopen the purchase price negotiation to account for the exit cost. He recovers $180,000 of it through contract adjustment. The lesson sticks: he now models the IRD at two rate scenarios in every closed-loan underwrite, regardless of intended hold period.
Pros & Cons
- Lower rate: Closed mortgages price below open equivalents, reducing carrying costs and improving cash flow from day one
- Predictable payments: Fixed-rate closed loans lock in rate and payment for the full term, keeping long-hold projections reliable
- Built-in discipline: The penalty creates a soft commitment to the business plan — useful for investors prone to over-trading or chasing unnecessary refinances
- Broad availability: Agency and CMBS products are closed by design; this structure gives investors access to the best institutional pricing
- Canadian standard: For Canadian investors, the 5-year closed is the default product with the deepest lender competition and sharpest pricing
- Expensive early exit: Mid-term payoff, sale, or refinance triggers a penalty that can reach $20,000–$200,000 on investment-grade loans
- IRD is unpredictable: The penalty depends on rates at the moment of prepayment — not at origination — making future exit costs impossible to model precisely
- Misses rate drops: If rates fall sharply after closing, you cannot refinance into savings without absorbing a penalty that may exceed the benefit
- Distress amplifier: A forced quick sale adds a non-negotiable penalty on top of already difficult market conditions
- Strategy mismatch: Short-hold deals — value-add flips, 2-to-3-year holds — should not be financed with closed 10-year agency loans
Watch Out
- IRD shifts daily: The penalty is calculated at the moment of prepayment using that day's rates, not origination rates. Run multiple rate scenarios (flat, down 1%, down 2%) before committing to a closed loan on any property where early exit is plausible.
- Lockout versus penalty period: CMBS loans distinguish between hard lockout (no prepayment allowed at all) and penalty period (exit permitted but expensive). Confirm which window your loan is in before modeling an exit.
- Canadian open premium: Open mortgages in Canada run 0.75–1.75% higher than closed. Unless a near-term sale is confirmed, the premium rarely pencils — but verify your exit timeline before defaulting to closed.
- Yield maintenance versus defeasance: Agency loans use yield maintenance (cash penalty); CMBS loans use defeasance (substitute Treasury securities). Defeasance requires a specialist consultant and upfront security purchases — factor that operational cost into your exit budget.
Ask an Investor
The Takeaway
A closed mortgage delivers the lender's best rate in exchange for a firm commitment to hold. For long-hold investors on stabilized assets, that trade-off is almost always worth it. The hazard is signing a closed loan onto a short-hold strategy — the prepayment penalty can turn a profitable exit into a scramble. Model the IRD at two rate scenarios before you close, and price a reasonable penalty into your underwriting even if full-term hold is the plan.