Closed Ended and Open Ended Loans

One major factor in the terms of a loan (such as length of loan, down payment or APR) is whether the loan is closed-end or open-ended. The distinction is very simple: if the loan has a fixed end-date, then the loan is considered closed-end. Otherwise, it is considered open-ended. Examples of closed-end loans include traditional mortgages and auto loans. Examples of open-ended loans include credit cards and home equity lines of credit.

Why do closed-end loans offer lower APRs?

Lenders like predictability. Whether it is the ability for a borrower to pay or when it happens, lenders enjoy their ability to predict exactly how a borrower will respond to payment demands. With a closed-end loan, the end date is entirely fixed. This means the lender is able to predict exactly when all of the money lent will be repaid. When you take out a 30-year mortgage for $200,000, you are indicating to the lender that you will pay back 100% of that $200,000 in a 30-year timeframe. Whether this comes by monthly payments, the sale of the house or a refinance of the mortgage, the loan is promised to be repaid in that timeframe. On the other hand, when you have a credit card with a $8,000 limit, lenders are unsure about whether you will borrow that $8,000 and when exactly that $8,000 will be repaid. This uncertainty for the lender increases the risk and, therefore, the APR.

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Why would you use open-ended loans?

Open-ended loans offer benefits that closed end-loans do not. Closed end loans often have a fixed (or, if not fixed, a large payment, such as an ARM). When people experience a cash crunch, such as if they pay a lot for gifts in Christmas, lose their job or are spending their money elsewhere (such as investing or paying a child’s college tuition), closed end loans are often the most difficult obligations to meet. You have to maintain the pay down curve because you have promised to pay down a debt at a certain rate. Open-ended loans do not have this problem. If you have a lot of cash and want to avoid interest payments, feel free to pay the entire balance. If you do not have a lot of cash, however, feel free to pay only the minimum. Open-ended loans offer flexibility.

Be sure to use the minimum payment option on open-ended loans cautiously. Usually, open-ended loans offer high interest rates (credit cards are notoriously high, HELOCs are lowish interest – but higher than traditional mortgages), so the cost to not paying the maximum are much higher than closed-end loans. The benefit to having open-ended loans, however is the flexibility in their payment structure. Thus, it is a great option to have them in your pocket in case you ever need them. If you don’t need them, then great.