How is Mortgage Interest Calculated?

Will interest rates come down in 2024? This has been the million-dollar question for the Bank of Canada (BoC). For investors, it is almost certain that the central bank will start pivoting on monetary policy and pulling the trigger on rate cuts. Indeed, now that inflation is inching closer to the institution’s 2 percent objective and the Canadian economy is close to recession territory, it might make sense for monetary authorities to start loosening conditions.

If so, this could be good news for anyone interested in acquiring a residential property in the Canadian real estate market. Of course, this leads to plenty of questions for prospective homebuyers, particularly on the subject of affordability.

Can you afford to buy a home in today’s housing market? Can you pass the stress test? What is the mortgage rate anyway? How is mortgage interest calculated?

Well, for that final question, we have you covered.

How is Mortgage Interest Calculated?

When a residential property – single-family home, townhouse, or condominium unit – is bought with a mortgage, the buyer is required to repay the amount they borrowed (principal) plus interest on the unpaid loan amount. The interest is the cost of borrowing the funds necessary to acquire a home.

How much interest is paid depends on a wide array of circumstances, such as the type of mortgage, amortization period (duration), size of loan amount, and your down payment. Your credit history, employment status, and personal finances will also play a role in the rate you receive from a mortgage lender.

Banks and mortgage lenders typically will finance around 80 percent of the property’s price. Borrowers will agree to repay the funds with interest over a period (usually 25 years).

There are two types of mortgage interest rates: fixed (the interest remains the same until the next renewal) and variable (rates are adjusted as per the lender’s prime rate, which is based on the BoC’s policy rate).

Here is how it would work, according to the Finance Consumer Agency of Canada (FCAC):

Let’s say you have a principal amount of $500,000 with a 25-year amortization period and a five-year term at a rate of six percent. Your monthly payments would be about $3,200.

Indeed, the more principal you pay, the lower your monthly interest payments, as mortgage interest is calculated as a percentage of the remaining principal amount. It is essential to understand that all mortgages, except variable rate mortgages, are compounded semi-annually. This means that if you are approved for a mortgage at a rate of six percent, your annual effective rate will actually be 6.09 percent, based on a rate of three percent semi-annually.

For most borrowers, the lenders will create a payment schedule that breaks down their monthly principal and interest payments. Initially, the interest payments are higher, but as more payments are made, the interest amount decreases, and more of the payment goes towards repayment of the principal.

The loan term also determines how much money you pay toward your mortgage each month. The longer the term, the lower the monthly payments, but the longer it will take to pay off the mortgage. A longer mortgage also means the overall amount of interest you pay on the loan will be higher as you pay for a more extended period.

What Influences Mortgage Rates?

In Canada, many factors can influence mortgage rates.

First, the Bank of Canada’s policy rate, the rate the institution sets at which money can be borrowed or lent out. Whenever the BoC’s interest rates are adjusted, the prime rate is also revised.

Second, the next thing that can impact mortgage rates is inflation. Lenders will generally raise interest rates when inflation is higher because the money they give to borrowers is anticipated to be worth less in the coming months.

Third, the bond market will contribute to mortgage rates because many lenders bundle mortgages and utilize mortgage-backed securities. Therefore, the price of these securities is connected to government bond prices and yields. Suffice it to say if bond prices jump, rates will fall. If bond prices fall, rates will climb.

Shop Around for a Better Mortgage Interest Rate

Financial experts regularly recommend shopping around for a good mortgage rate when purchasing a residential property. Lenders are often able to provide borrowers a discount if they have a sound financial standing. All you need to do is negotiate. Likewise, shopping around and comparing rates from different lenders is always a good idea. Never settle for the first rate offered to you, as there may be lenders out there who might be willing to give you a better rate.

And what about variable-rate mortgages? In many cases, they are lower than fixed-rate mortgages, but there is always the possibility that the rate could go up during the term, depending on the prime rate.

In the end, work with your real estate agent and lender and know what you can afford.