How is Mortgage Interest Calculated?

how is mortgage interest calculated FI

Are you trying to get a mortgage from a lender?  Two of the top things you may be considering include the cost of the loan and the amount you can borrow. Before applying for the mortgage,  you will see that the lender has advertised a specific interest rate. For instance,  the lender may state that they offer a fixed interest rate of 2.19% for two years or a variable interest rate of 2.9%  for three years, etc.  

Are you trying to understand how mortgage rates work? Do you want to know how lenders set the rate?  In this article, we will also cover how the mortgage interest payable is computed. So let’s get started. 

How do mortgage rates work in Canada? How are they set?

“How are mortgage rates determined in Canada?”  It turns out that this is a popular question asked by many people.  And the first thing to understand is that the Bank of Canada has stated that they don’t control the mortgage rates directly. But The Bank of Canada has an impact on mortgage rates around the country.  

The BoC does this by controlling the policy interest rate. Generally, this rate determines the amount of interest major banks and institutions can charge among themselves for lending to each other.  It has a remarkable influence on rates for personal loans and mortgages. For instance, if the cost of borrowing is increased, mortgage interest rates, in turn, are increased.  Additional factors that influence mortgage interest rates include: 

  • Economic performance: When governments want to stimulate economic growth,  they tend to lower the interest rate to decrease capital cost. This also influences people to borrow and invest. On the other hand, increased interest rates cause people to save money so that they can earn interest on savings accounts.
  • Demand for money within the economy:  In a period of high economic growth, there are certainly more investors and companies applying for loans.  The interest rates climb up to reflect this demand. Therefore, if the mortgage provider wants to borrow money from investors,  it must also pay good interest rates.
  • Influence of the global economy: Events taking place far from our borders may significantly impact mortgage rates than you ever imagined. Turbulence events elsewhere have a far more impact than positive events since investors scramble to store their money in safe economies like the US or Canada. 
  • Housing market: If more people in the country are making applications for mortgages, the interest rates are expected to go up.  Consequently,  if more people choose to rent than buy and there are few properties on sale,  this decreased demand puts downward pressure on mortgage rates. 
  • Inflation:  During a period of high inflation, the purchasing power of the Canadian dollar is reduced, and consequently, prices of items are pushed up. Interest rates on mortgages are not exempt, and even houses may become more expensive. 
  • Costs incurred by the lender:  If you borrow a mortgage from a bank, they have to pay interest on savings accounts if they took out the money from their customers. They will also have operational costs that need to be factored into the interest.  Additionally,  they factor in the costs associated with the risk that you may default on the loan. The bank may also include the profit they want to make in the interest rate. 

Understanding mortgage rates: How consumer & product specific factors that influence the rate

The perceived risk may influence the mortgage interest you pay.  See, when the lender gives you a mortgage, two likely scenarios could happen.  You can successfully pay off the monthly payments or default on the loan payments and undergo foreclosure. The lender will look at certain factors when assessing your credit risk, including: 

  • Credit score:   Your credit score gives the lender an indication of your probability of repaying your debt based on your prior debt history. Credit scores range from 300 to 900, and having a credit score of 680 and above, puts you among the people most likely to receive the lowest interest rates from mortgage lenders. 
  • Down payment:  If you take out a mortgage that is more than 80% of the value of your property,  the lender assumes that you have less skin in the game. The perceived risk is more.  That’s why you’re required to sign up for a mortgage default insurance, and the lender may also charge a higher interest rate.
  • The negotiation term: In Canada, mortgages have an amortization period and a loan term that ranges from a few months to 10 years. After the loan term expires,  you have to  renegotiate a new interest rate or amortization period with the lender.  Borrowers with longer fixed loan terms, for instance, ten years, pay a higher interest rate than those opting for a shorter renegotiation period.
  • Open mortgages vs. Closed Mortgages:  Do you want to take out a mortgage that you can pay off early before the end of the amortization period? This type of mortgage is referred to as an open mortgage, and it allows for prepayment without any penalties. The interest rate for an open mortgage tends to be higher than that of a closed mortgage by 1%.  The increased rate comes from the risk of prepayment, which means that the lender will not make sufficient profits on the said mortgage.
  • Fixed vs variable rate: Fixed rates tend to be higher than variable rates. That’s the lender can make revisions on a variable rate easily based on changes to their prime lending rate. Because the lender may review rates anytime, they are less at risk if the market rates climb. 

How to calculate mortgage interest 

Calculating mortgage interest requires that you first know the rate the lender is going to charge you.  We recommend checking the rate by applying to as many lenders as possible.  This is referred to as shopping around,  and it can prove difficult, especially if you are familiar with the market. 

Loan Geeks can make it easier for you to get the best rates without even affecting your credit score.  We have access to some of the top mortgage brokers in Canada, and you can receive up to 5 quotes simply by filling out the form on this page.

Don’t have what it takes to qualify for a mortgage from a traditional financial institution? 

Loan Geeks Can give you access to the private mortgage market in Canada. Private lenders consider consumers with below-average incomes,  negative debt-to-income ratios,  prior bankruptcies,  etc.   

You can receive interest rates quotes from these lenders via our private mortgage lenders page. 

Before calculating mortgage interest, ensure you know all the terms of the mortgage, for instance: 

Asking price$500,000
Downpayment25% ($125,000)
Amortization period15 years 
Repayment frequencyMonthly
Mortgage rate1.74% 5-year fixed 

Now with this information,  just find an easy to use mortgage interest calculator. Plugging in the values will inform you of the expected monthly payment. 

For instance,  in this example, the monthly payment amount will be $2,367.45  if the interest rate stays consistent until the end of the amortization period.  

The actual computation of the monthly payment amount can be done by hand using the following formula: 

Monthly payment amount  =  Principal  loan amount [ monthly interest rate (1+ monthly interest rate)^ number of months] / [(1+ monthly interest rate)^ number of months-1]  

But it’s much easier to compute using an online calculator. 

When the mortgage interest is calculated using fixed terms, there will be a balance after consecutive terms before the new interest rate and amortization period are determined for the rest of the term. For instance, since we chose a 5-year closed rate in the example above, by the end of the first fixed period,  we would have made total payments of  $142,047.00 and paid a total interest of $27,700.97. 

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Are you looking for a quick solution on how to calculate mortgage interest? Use the free mortgage calculator provided by the Financial Consumer Agency of Canada at the government site here

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