Understanding the basics of mortgage interest
By ATB Financial 12 May 2021 4 min read
Buying a home is one of the biggest decisions you will make in your lifetime. For most people, buying a home also means getting a mortgage. When you borrow money under a mortgage, the lender will charge you interest based on the borrowed amount and the time it takes for you to repay them.
Here’s what you need to know about mortgage interest and how it works at ATB.
How does mortgage interest work?
When you finalize the details of your mortgage agreement, you’ll agree to an interest rate with your mortgage provider. There are two main types of mortgage interest rates—fixed and variable.
With a fixed rate mortgage, your interest rate won't change for the term of your agreement. Currently, the longest term that you can get is five years. With a variable rate mortgage, the interest rate changes according to your mortgage provider’s prime rate and the amount you pay in interest can fluctuate.
How is mortgage interest calculated?
Calculating mortgage interest can get complicated, but it starts with looking at four factors:
- The outstanding principal (amount borrowed) at the start of the calculation period
- The mortgage interest rate
- The time period you’re calculating interest for
- How often the interest compounds on the principal (amount borrowed)
How mortgage payments work
Each time you make a scheduled mortgage payment, a portion of your payment will go toward paying down the principal, or the amount you borrowed, and a portion will go toward paying interest.
Earlier in a mortgage, a larger portion of the scheduled payment will go towards paying interest owed. However, as you pay down the amount you borrowed and owe less, the scheduled payment will apply more to the principal balance. This happens because interest is calculated based on outstanding principal that gets smaller and smaller over time as scheduled payments are made.
It’s also important to note here that any lump sum payment you make on your mortgage will only apply to the principal and not pay any interest. But, you’ll save interest on future payments because the portion that will go toward paying interest will get smaller because the lump sum payment will have reduced the principal in any event.
Understanding compound interest
Compounding interest happens when outstanding interest on a mortgage is added to the mortgage principal amount for future interest calculations. In Canada, mortgage providers have to compound any outstanding mortgage interest at least every six months.
Your payments will be calculated to ensure your loan is paid to zero within the agreed-upon time and your principal never takes a net increase. However, things like payment deferrals can change this math.
How ATB calculates and compounds mortgage interest
At ATB, we calculate mortgage interest assuming each month has 30 days, for a total of 360 days in the year. We do this mostly because it makes the math simpler and easier to understand for everyone involved. Plus, with this method, you save five days of interest per year.
This can make your interest payments look a little strange, specifically in February when you will generally pay two “extra” days of interest. This is offset and then some over the life of your mortgage by “interest free” days in the months with 31 days.
Although every mortgage loan lender must compound mortgage interest as required by Canadian laws, ATB does this a little differently. We build compounding into the formula we use to calculate your interest. So, every time we calculate your interest, we are calculating as if it had compounded at a certain frequency without ever actually adding it to your principal. The compound frequency used depends on the mortgage conditions selected.
We use other versions of this method for different loan products we offer, but this is ATB’s standard for all residential mortgage products.
Why ATB calculates mortgage interest this way
The main benefit of this method is that your principal doesn’t go up and down throughout the mortgage’s lifespan, if you make all of your payments as planned. As seen in the chart below, with a different way of compounding interest on a mortgage loan, how much you owe will increase. These increases or “spikes” occur because the interest for the period is determined as a straight calculation each day and held in an outstanding interest account. Then it all gets added back onto the principal on the compound date. When it gets added back, you see the spike.
With ATB’s method of calculating and compounding interest, your balance doesn’t spike. Mortgage interest is calculated at the end of each month and when you make a payment. Each payment pays any outstanding interest first, then the rest goes to the principal. This method eliminates those upward spikes on your balance.
Instead, you’ll see a steady and smooth decline in the amount owed, simply illustrated below. At any time, you’ll be able to see how much you owe on the mortgage without having to think about interest spiking on compound dates. We like this because it makes repayment more predictable for our clients.