In Canada, the posted mortgage rates are annual, but are capitalized each semester. This means that the nominal rate you are given is not the actual rate you are paying. The latter is usually slightly higher.
For example, let’s take a fixed annual rate of 3%. We’ll start by finding the actual annual rate, and then determine the periodic rate, which is the one applied to your payments.
Since capitalization occurs twice a year, the periodic rate can be calculated by applying the following formulas.
Posted annual rate / Number of capitalization periods
For our example, that gives:
3 % / 2 = 1,5 %
Through capitalization, we also get our new annual rate :
( 1 + Rate per capitalization period)Number of cap. periods - 1 = Actual annual rate
Our example gives us : (1 + 1,5 %) 2-1 = 3,0225 %
Since payments are made on a monthly basis (12 times a year), bimonthly (24 times a year) or every two weeks (26 times a year), we must adjust according to frequency.
If payments are monthly, the periodic rate is calculated as follows :
(1 + 3,0225 %) 1/12 -1 = 0,248452 %
Until the mortgage term comes to an end, each of your payments will go towards paying 0,248452 % of interest on the balance, and the rest will go towards reducing your capital (the amount of the loan).
The more you pay back your mortgage, the lower the portion of your payment going towards the interest will be, and the more the portion going towards the capital will increase.
By adding a payment to your regular payment, you’ll reduce your capital, which in turn will lower the portion going towards interest for your next payment. Make sure you respect the terms of your mortgage contract in regards to capital repayment.
This also explains why a shorter amortization period will wind up saving you a lot of money in interest fees.