When shopping around for a mortgage, most people know they want the lowest interest rate possible without giving up some flexibility in other mortgage features. But how much does an extra .5 per cent really make on the total cost of your mortgage?
Let’s take a closer look.
If you get a mortgage for $350,000 at an interest rate of 2.7 per cent with an amortization, or loan term, of 25 years, then over the life of your loan you’re going to end up paying $131,692 in interest if you make monthly payments. If you get that same mortgage amount and loan term with an interest rate of 3.1 per cent, then you will end up paying $153,400 over the life of your loan, again, if you’re making monthly payments. That measly .25 per cent will end up saving you $21,708 in the long run. Of course, you almost certainly won’t keep the same interest rate for the entire amortization period, so how much you’ll save will vary, but you can see how big a difference a small change in interest rate makes.
Given these calculations, it’s not difficult to understand why home buyers want to get a mortgage whenever it seems as if interest rates are rumoured to rise, even if that means moving funds around in other areas or getting a guarantor for the loan. Unless something drastic happens, chances are that interest rates won’t spike a percentage point or two overnight. That being said, every basis point matters (a basis point being one hundredth of one per cent), and has a direct impact on the amount of money that you’re paying for your property – and how much is left in your bank account when it’s all said and done.
How are interest rates applied to your mortgage?
Another key to understanding the impact of interest rates is to understand how they’re applied to your mortgage.
Settle in, because this one’s a doozy.
You should already know that your mortgage has two parts: the principal and the interest. Figuring out how interest rates are calculated isn’t as easy as taking your given interest rate, applying it to the principal, adding the interest and principal, and then dividing the total by the number of months left in your loan to get your monthly payment amount. That kind of interest is called simple interest. The interest is only calculated on the principal balance, and there is no compounding.
Compounding, as you may know from looking at some of your bank account statements, is when interest accrues at set intervals based on the amount at any given time. If the interest on a particular account is compounded monthly, then the balance each month builds on the last, and the balance is greater at the end than it would be if the interest was only calculated once a year. So if you had a bank account balance with $100,000 with a 10% interest rate and it was compounded monthly, it would look something like this:
.1/12 (convert 10% into a monthly rate) = .0083
At the end of month one, you’d have $100,000 x .0083 = $833 ($100,833)
At the end of month two, you’d have $100,833 x .0083 = $840 ($101,673)
At the end of month three, you’d have $101,673 x .0083 = $847 (102,520)
You can see how this adds up much faster than interest compounding at an annual rate.
Depending on the type of loan and the lender, compounding varies. By law, fixed rate mortgages in Canada are compounded semi-annually, which means that twice a year, unpaid mortgage interest is added to the principal amount of the loan. This leaves you with what’s called an actual interest rate, the rate that you’re quoted, and an effective interest rate (aka the real interest rate, the effective yield, or the APR), which is what you actually end up paying. And often, the actual interest rate that’s quoted is so much lower than the posted rate, the standard benchmark rate, that people don’t pay much attention to the details beyond that.
“People don’t really pay much attention to it, says Scott Westlake, founding partner and mortgage agent with DLC Denova Group. “I think a lot of the times it’s about advertising the posted rates online on one of their 150-page websites, but bankers aren’t really talking about posted rates, [brokers are] not really talking about posted rates, the only time we’ll bring it up is when we’re talking about mortgage penalties.”
The more frequent the compounding period, the higher the effective interest rate will be. Since all Canadian mortgages apart from variable rate mortgages only compound twice a year, the real interest rate ends up being only slightly higher than the interest rate that was agreed to when you signed your loan documents.
York University Schulich Business School professor Alan Marshall wrote “A Guide to Mortgage Interest Calculations in Canada,” in which he explains, “If you are quoted a rate of 6% on a mortgage, the mortgage will actually have an effective annual rate of 6.09%, based on 3% semi-annually. However, you make your interest payments monthly, so your mortgage lender needs to use a monthly rate based on an annual rate that is less than 6%. Why? Because this rate will get compounded monthly. Therefore, we need to find the rate that compounded monthly, results in an effective annual rate of 6.09%.”
For variable rate mortgages, the compounding period varies, and to make things even more complicated, most mortgage payments are blended payments, which means that they consist of payments to both the principal loan amount and the interest charged by the lender as a fee for borrowing that money.
If you’re not particularly partial to doing the math, there’s no need to sweat it. o be honest, you don’t actually need to know how interest is compounded on your mortgage. When you’re looking at mortgages and determining how much the interest rate contributes to your bottom line, your lender does the math for you so there’s no need to get out your paper and your #2 pencils. You can make use of the mortgage calculators available to see how much you’re paying in interest and what your payments will be. But once you do know how compounding works, it’s hard to ignore every little basis point increase or decrease of your interest rate. If anything, your takeaway from all of this might be to make sure you’re asking about the effective interest rate when you’re shopping around and comparing mortgage products. Whether you go directly to a lender or go through a mortgage broker, they should both be able to tell you your effective rate, which may differ slightly from the initial rate that they’re offering.
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