Understanding how interest is calculated
Whether shopping for a mortgage or other types of financing, everyone is always looking for the best interest rate. But what is hiding behind that number? Do you really know how it’s calculated? Multi-Prêts offers simple, practical tools to estimate your payments. If you want to understand the operations performed by these calculators, read on for explanations that will shed a light on the process.
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.
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Other types of loans and financing
In many cases, other types of loans are calculated monthly, and sometimes even daily. Using the same mechanics, this inflates the actual rate, that is to say the rate you are really paying.
An unpaid balance on a credit card with a 20% interest rate will wind up costing you more than 20% down the line. That’s why it’s important to avoid large debt on this type of financing, especially on cash advances, as the interest is often compounded daily.
It’s not only about the rate!
The interest rate is certainly an important part of a mortgage, but you can’t forget about the other conditions. Read our article to find out more about mortgage conditions.
Need more explanations ?
Contact a Multi-Prêts broker to better understand interest calculations, amortization, and all things mortgage-related.