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Mortgage Interest Compounding in Canada: How It Works and What You Need to Know
October 21, 2024 | Posted by: Yelena Markus
In Canada, fixed-rate mortgages are legally required to compound semi-annually, meaning interest is calculated and added to your balance twice a year. In contrast, variable and adjustable-rate mortgages often compound monthly, although some lenders may align compounding with your payment schedule. It's crucial to understand your mortgage's compounding period, as it impacts the total interest you'll pay over the life of the loan.
The more frequently interest is compounded, the more it will accumulate, as interest-on-interest charges increase. Any unpaid interest gets added to your balance, raising the total amount on which future interest will be based. Semi-annual compounding benefits borrowers by reducing interest accumulation compared to monthly compounding.
Understanding the Effective Annual Rate (EAR)
The Effective Annual Rate (EAR) reflects the real cost of borrowing by considering how often interest is compounded. This calculation allows you to compare different mortgage options more accurately.
The formula for EAR is:
EAR = (1 + interest rate ÷ n)ⁿ - 1
Where:
- n = number of compounding periods (2 for semi-annual, 12 for monthly)
Example:
For a 5% interest rate with semi-annual compounding:
EAR = (1 + 0.05 ÷ 2)² - 1 = 0.05063 or 5.06%
For the same 5% interest rate with monthly compounding:
EAR = (1 + 0.05 ÷ 12)¹² - 1 = 0.05116 or 5.12%
Mortgage Principal and Interest: Payment Breakdown Example
The table below demonstrates how mortgage payments gradually shift from interest-heavy to principal-heavy over time. It illustrates the breakdown of payments for a $500,000 mortgage with a 25-year amortization and a 5% fixed interest rate, assuming monthly payments.
| Year | Beginning Balance | Principal Paid | Interest Paid | Ending Balance |
|---|---|---|---|---|
| 1 | $500,000 | $10,386 | $24,510 | $489,614 |
| 5 | $455,192 | $12,655 | $22,242 | $442,538 |
| 10 | $385,180 | $16,199 | $18,697 | $368,981 |
| 15 | $295,558 | $20,736 | $14,160 | $274,822 |
| 20 | $180,834 | $26,544 | $8,352 | $154,290 |
| 25 | $33,979 | $33,979 | $918 | $0 |
How to Calculate Mortgage Interest
To calculate your interest payments, you'll need to know your mortgage principal, interest rate, and payment schedule. Here’s the formula:
Interest Payment = [(1 + i ÷ m)ᵐ ÷ n - 1] × Principal
Where:
- i = annual interest rate
- m = number of compounding periods per year
- n = number of mortgage payments per year
Examples:
- Monthly payment on $500,000 at 5% interest:
Interest = [(1 + 0.05 ÷ 2)² ÷ 12 - 1] × $500,000 = $2,061.96 - Bi-weekly payment:
Interest = [(1 + 0.05 ÷ 2)² ÷ 26 - 1] × $500,000 = $950.62 - Weekly payment:
Interest = [(1 + 0.05 ÷ 2)² ÷ 52 - 1] × $500,000 = $475.08
Bi-Weekly vs. Monthly Payments: What’s the Difference?
Switching from monthly payments to bi-weekly payments accelerates your mortgage payoff and reduces the total interest paid. Bi-weekly payments mean you’ll make 26 payments per year instead of 12, which reduces your principal faster and lowers interest over time.
Impact of Amortization on Mortgage Interest
Amortization is the length of time it takes to fully repay your mortgage through regular payments. A longer amortization period results in lower monthly payments but increases the total interest paid over time. Shorter amortization periods increase your monthly payment but help you save on interest.
Here’s a comparison of amortization periods for a $500,000 mortgage at 5% interest:
| Amortization Period | Monthly Payment | Total Interest Paid | Total Cost (Principal + Interest) |
|---|---|---|---|
| 20 years | $3,285.63 | $288,550.04 | $788,550.04 |
| 25 years | $2,908.02 | $372,407.48 | $872,407.48 |
| 30 years | $2,668.45 | $460,643.22 | $960,643.22 |
Reducing your amortization from 25 to 20 years increases monthly payments by $377.61 but saves $83,857.44 in interest. On the other hand, extending from 25 to 30 years reduces monthly payments by $239.57 but increases interest by $88,235.74.
Tips for Reducing Interest and Paying Off Your Mortgage Faster
- Increase Payment Frequency: Opt for accelerated bi-weekly payments to reduce interest and shorten your amortization.
- Shorten Your Amortization Period: Higher payments mean less interest over time.
- Make Lump-Sum Payments: Use prepayment privileges to reduce your principal and lower total interest costs.
- Refinance Strategically: If interest rates drop, refinancing your mortgage can help you save on interest.
Understanding how interest and compounding affect your mortgage can help you make informed decisions and save money over time. As a mortgage broker in Montreal, I’ll help you find the right mortgage product tailored to your financial goals and guide you every step of the way—whether you're purchasing your first home or refinancing an existing one.
