You probably never thought to ask how frequently your mortgage interest is compounded. It's there in your mortgage contract, and it's important to know before you sign.
Semi-annual compounding is the industry standard for fixed-rate mortgages — but for variable rates (that change according to bank prime rates), some lenders may charge you at a monthly or even weekly frequency.
That higher compounding frequency can increase the ‘real’ rate you pay (your effective annual rate or EAR), despite your contract rate.
Long-time True North Mortgage broker, Jacky Cheong, wants his clients to be aware of this detail, especially if they're comparing rates from lenders and trying to get a deal.
“I see some lenders offering a slightly lower variable rate to be competitive,” Jacky states, “but with the monthly (vs. semi-annual) compounding in the fine print, the deal isn't as good as it looks."
What does ‘compounding frequency’ mean?
For every mortgage, interest is calculated at intervals and added to the principal loan amount. Depending on the frequency, you could end up paying more ‘interest on interest’ to noticeably accrue extra interest costs over time.
Semi-annual is considered the 'fair' frequency
Federally required for fixed-rate mortgages — semi-annual is also considered the 'fair' frequency on variable-rate mortgages.
However, unlike a fixed rate that doesn't change during your term, variable rates cost more for banks to manage, so the compounding frequency is subject to lender discretion, allowing them to increase it for your mortgage loan if they wish.
When might you run into monthly compounding?
Some big banks might sneak in monthly compounding for their fixed-payment variable-rate mortgages. Fixed payments make up about 75% of variable-rate mortgages in Canada.
(Floating payment variable rates are usually offered by non-big-bank mortgage lenders and typically come with semi-annual compounding.)
Also, online-only mortgage platforms may use this method to offer a ‘bargain-bin’ rate up front but then plump up your ‘real’ rate after the fact to boost their bottom line.
Apples to apples: Compare rates for the ‘real’ cost of compounding
To illustrate the extra cost, consider these two scenarios with the same $400,000 mortgage, 25-year amortization, and 5-year variable rate of 5.0%:
- Semi-Annual Compounding (Standard): Effective annual rate becomes 5.06%, with a monthly payment of $2,326.
- Monthly Compounding: Effective annual rate becomes 5.12%, with a monthly payment of $2,338.
Over 5 years, the monthly compounding frequency could cost you an additional $1,000 in interest compared to semi-annual. Over 25 years, that figure jumps to over $3,500.
This difference is even more pronounced if your contract rate is higher: with a 6.0% rate, you’d pay about $1,400 extra over 5 years and about $5,400 more over 25 years.
Is weekly compounding even more expensive?
After the bump up from a semi-annual to a monthly frequency, the compounding math peters out. Slightly higher interest costs from weekly calculations would only be perceptible at higher mortgage rates (such as 6% or 7%).
Get unbiased mortgage advice from the experts at True North Mortgage
According to Jacky at True North, their clients are the apple of their (mortgage) eye. They advocate on their client’s behalf, ensuring transparency of the mortgage details to help them choose the best rate and right mortgage option that fits their situation and financial goals.
If you prefer a fixed-payment variable rate, they can compare rates with lenders that use semi-annual and monthly compounding to help you save the most while still getting your best rate.
Whether your mortgage needs are straightforward or more complex, they have the most 5-star reviews in the business for a reason — they put you first and simplify your process to save thousands, term and term again.
Not sure which rate to choose, fixed or variable? Get expert advice from brokers in your preferred language. A few minutes could save you a pile of cash, online or in-store. Contact Canada's No. 1 Mortgage Broker today.