Some people wonder how is mortgage interest calculated. There are actually two answers depending on what type of mortgage interest you’re talking about: The interest rate you’re given and the actual amount of interest you’d pay.
Buying a home is a huge purchase, and a mortgage is a lot of money, especially knowing that you will have to pay interest on top of paying back the principal. Understanding how mortgage interest is calculated is an important step in better understanding your mortgage and how you can save on those interest payments.
What is interest?
Interest is the fee that you pay a mortgage lender in exchange for borrowing money. It’s the money you will have to pay over the life of the loan amount. We’re used to paying interest on a number of things; credit cards, auto loans, student loans etc. For your mortgage, your lender will offer you different interest rate options, and you will have to renegotiate your interest rate every time you renew or refinance. Interest rates will also fluctuate over time depending on your financial standing as well as the current economy.
How is mortgage interest calculated?
So, how does mortgage interest work? Mortgage interest rates are calculated on an individual level. There are several factors that the lender takes into consideration when determining your mortgage rate. These factors include:
- Your credit history – A better credit score means being offered a better rate.
- The current prime rate – Lenders look at the Bank of Canada’s prime rate to determine their interest rates.
- The current posted rate – This is the default rate that lenders advertise for their products. This affects variable-rate mortgages.
- The length of your mortgage loan term – A shorter term typically gets better rates.
- The type of interest you choose – Fixed and variable-rate mortgages come with different monthly interest rates.
- If you qualify for a discounted rate – This is a rate that is lower than the posted rate. Ask if your lender can offer you a discount as it can save you thousands of dollars.
- If you are self-employed – Being self-employed is often seen as a higher risk when it comes to paying back a mortgage, so this may result in a slightly higher rate.
Mortgage interest formula
Your mortgage rate can sometimes be a bit deceiving since it doesn’t factor in compound interest. There are plenty of online mortgage calculators that can help you figure out your annual interest rate, but you can also calculate it on your own if you so desire.
To do this, you will want to know the effective rate of your mortgage. This is the real rate, and it’s often higher than the posted rate because it does take into consideration the compounding interest. The more often your interest is compounded, the higher the interest rate.
Once you have your payment amount, you will also need the PV factor. This is the total number of mortgage payments.
To calculate your mortgage rate, you can use the following mortgage rate formula:
Principal = (PV Factor) x (Payment)
Payment = (Principal) / (PV Factor)
Total payment amount= (Principal)/ (Payments)
Again, you can use this mortgage rate formula if you like, but it’s much easier to use an online mortgage calculator. The Government of Canada has a free mortgage calculator here.
How much interest can cost
A mortgage is a very large loan that generally takes a couple of decades to pay back; some people have a 30-year mortgage. Even if you have a low interest rate, that seemingly small amount can add up to a large sum of money over time. This is why ensuring you get the best interest rate possible is so important. You also need to consider the possibility of interest rates increasing over time and factor that into your budget to ensure that you can afford it based on your monthly income and other expenses.
To give you an idea of how interest rates can affect your monthly payments, take a look at the chart below that has mortgage amounts of $350,000, $500,000, and $650,000. These numbers assume a 25-year amortization schedule. Property taxes and a homeowners insurance policy are not included.
What is a fixed interest rate mortgage?
When it comes to interest rates, you will be asked to decide whether you would like a fixed interest rate mortgage or a variable interest rate mortgage for your monthly payments.
A fixed interest rate mortgage means that your rate is locked in and will stay the same for the duration of your mortgage term, even if the Bank of Canada’s interest rates fluctuate. This can be a huge benefit if interest rates increase during your term, but it can also be a disadvantage if rates drop during your term.
Fixed rates tend to be higher than variable rates because they are ‘safer’ in that you know exactly how much you will need to pay for the length of your term. If you are an individual who wants that security in knowing that they have a consistent monthly payment amount or if you are concerned that rates may increase in the near future, then it’s a smart way to go.
What is a variable interest rate mortgage?
The other option is to choose a variable interest rate mortgage (sometimes referred to as adjustable-rate mortgage). In this case, the regular monthly mortgage payment is constant, but the interest can fluctuate depending on market conditions which will impact how much of the principal you end up paying off each month. If the rates decrease, then more money goes toward your principal. However, if it increases then you pay more in interest.
Variable interest rate mortgages do tend to be more flexible and have lower rate offers than fixed mortgages, but they do come with more risk.
Adjustable payment variable rate mortgage
Another option to look into is an adjustable payment variable rate mortgage. In this case, the amount of your payments changes as the interest rate changes. So, the same set amount will be applied to the principal, but the interest portion will increase or decrease as rates change. This way you will always know how much is going towards the principal. However, while the possibility of lower monthly payments is a big perk, you also need to ensure you can handle the possibility of higher monthly payments if interest rates increase.
How your credit rating affects your interest rate
Something you want to be very mindful of when applying for a mortgage is your credit rating, as it can play a huge role not only in being approved for a mortgage but also in how lenders set your mortgage rates. Lenders do look at your credit report and your credit score to determine how much of a risk you are. If you have poor credit, they might deem you as too risky and deny you a mortgage loan. On the other hand, if you have strong credit, you’re more likely to get a discounted interest rate.
How to get the best interest rates
Mortgage interest can add up to quite a bit so you want to ensure you get the best interest rates possible. Some of the ways to do this include:
- Make sure you are in a strong financial position with a healthy credit score and history
- Ask for a discount
- Save up for a healthy down payment
- Shop around
- Work with a mortgage broker who can help find the best deal for you as a potential homeowner.
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