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It is no secret that most financial products are notoriously incomprehensible. It often requires people with extensive experience and/or education to really figure out what a loan or an insurance deal will cost in the end — and mortgages are no exception.
But mortgages are very popular and very “big.” They operate with large sums of money and — more importantly — with your property. This is why, with inspiration from Dave Larock, I decided to bring you a very interesting tip regarding variable-rate mortgage interest compounding.
The Concept of Compounding
Compounding interest is a very nice feature as long as it applies to your deposits or investments. It is a little more painful, however, when it is applied to the money that you owe. Most notably, it is a great way to significantly complicate the comparison between various financing products.
The problem is that the compounding surplus is dependent on the frequency of compounding periods. The more often compounding takes place, the more expensive the effective (or real) interest rate. Therefore, monthly repayments are in effect more expensive than semi-annual or annual repayments with the same nominal interest rate.
Knowing this, it won’t surprise you that a 10% loan compounded annually is actually cheaper than a 9.6% loan compounded monthly.
Compounding Period vs. Payment Period
Please note that with variable-rate mortgages, the number of compounding periods may differ from the number of payment periods. Make sure you know the former as well as the latter when you are deciding on the deal since both figures have an impact on your final cost.
If you do not receive this information early in the mortgage application process, ask for it. Section 6 of Canadian Interest Act requires lenders to disclose the Annual Percentage Rate (APR) to borrowers before the deal is signed. This is the effective yearly rate that you will be paying, calculated by a standard, prescribed formula.
Now, a higher frequency of payments may decrease your total interest expense slightly because you are decreasing the principal from which the interest is calculated a little faster (or, rather, more evenly). The effect of this is usually negligible, however — especially if you are facing any transaction fees.
On the other hand, the number of compounding periods can have quite a significant impact on the total cost of a loan, as demonstrated above.
Dave Larock provides this handy example of the compounding difference in his blog post:
Interest Rate Compounding Table by Dave Larock
I hope that these few tips will save you a few bucks and that you will now feel more informed and empowered when negotiating your next mortgage deal.
If you want to learn more about home financing, please check out my Guide to buying a Toronto home: Planning your finances.
This article is based on a great post by David Larock, an expert on consumer mortgage products and an experienced Ontario mortgage planner. Read David’s post on Interest-rate Compounding: A Devil in the Detail for more information on mortgages and interest rates.