Mortgages
How Canadian Mortgages Charge Interest
In words you can understand!
In Canada, like in any country, mortgage interest is the “serial killer” of our finances. Why? The answer is simple. It’s called compounding and its secret weapon is that it charges you interest on interest! That’s right, not only do we pay interest on the money we borrow to buy our homes, but twice a year in Canada, the bank charges us interest on the the interest that has accrued “so far”.
It works like this. Imagine we borrow $200,000.00 from the bank at 6% interest per year compounded monthly. The monthly payment on such a loan would be $1288.61 and the total interest to be paid over 25 years would be over $185,000.00! If we wanted to manually calculate how we got to that crazy interest number we would need to follow the following formula:
- First, we have to calculate how much interest will accrue in the first month. To do this we find out what 0.50% of $200,000.00 is (1/12 of 6% for one month).
0.50% x $200,000.00 = $1,000.00 - Second, we need to add the first month’s interest to our initial principle.
$200,000.00 + $1,000 = $201,000.00 - Third, we subtract the monthly payment we would have made at this point from the $201,000.00 and now our new principle balance, to begin the next month, will be $199,711.39.
$201,000.00 – $1,288.61 = $199,711.39 - The last step is for us to charge 0.50% interest on $199,711.39 for the next month and repeat the 4 steps for each month until we reach 300 months (25 years)
1.005 x $199,711.39 = $200,709.95 …etc.
If you try following that through for 12 months on a piece of paper, you will quickly realize how futile that approach is. We simply have to find a way to pay down the principle faster than that or forfeit the right to complain about the incessant flow of interest from our pockets to the bank’s vaults.
In Canada, the interest only compounds twice a year, not 12 times a year which is better than our neighbours to the south but semi-annual compounding is more than enough compounding to keep most of us in debt for life! If you have a mortgage and didn’t understand how serious this is, now you do. Now ask yourself what you are going to do about it? If you do not have a plan to pay your mortgage off in a reasonable amount of time (10 years or less) then your mortgage will own you and the interest will be relentless.
Find out more about the rules of mortgages…you won’t believe how simple the rules are to understand once they are explained in a language you can understand.
Tired of reading? Talk to us today! We are always happy to answer your questions.
