With different banks offering significantly different mortgage rates, a common question I’ve been getting is, “Why?” If banks want to stay competitive, shouldn’t their rates be similar? And if a bank is offering significantly lower rates, how are they still making money?
The answer is complex and depends on several factors. For example, some banks may lower rates to gain market share, even at a short-term loss. Others aim to increase the number of mortgages on their books so they can later bundle and sell them to investors (which I’ll explain in a later article). Additionally, banks may offset lower mortgage rates by compounding interest more frequently, therefore making you potentially pay more interest than at a higher rate with less frequent interest compounding. This last point seems to be less understood, so I wanted to focus on it in this article.
Please bear with me because this is a bit technical, so I’ve tried to simplify it as much as possible.
What is Mortgage Compounding Interest?
Before I can answer this, I must explain mortgage per diem, which is a fancy way of saying that there’s a daily interest amount that applies to mortgages. Daily interest starts to accrue from the date of your last payment and continues to accrue every day, until the next payment comes out. Unless you’re in an interest-only mortgage, some of your payment will go towards clearing this interest, and some towards the actual loan. Here’s an example to illustrate this:
Say you have a $300,000 mortgage at a 5% annual interest rate, the per diem interest would be:
($300,000 × 5%) ÷ 365 days in a year (this varies from lender to lender) = $41.10 per day
This means you accrue $41.10 in interest every day until your next payment.
Compounding interest means you pay interest not just on the original loan amount but also on any interest that has built up over time. In other words, you end up paying interest on interest. This makes the total cost of the loan higher compared to simple interest, which only charges interest on the original amount.
In Canada, mortgage interest must be compounded at least every six months. However, some lenders—including certain major banks—compound interest monthly (or even daily) which can have a significant impact on the total interest you pay during your term (meaning that your “real” interest rate is much higher than your contract rate).
So, while you are paying the accrued interest since your last payment, the interest compounding means that any unpaid interest would be added to your loan balance, affecting future interest calculations.
How Does Compounding Affect Mortgage Borrowers?
The way interest is compounded directly impacts how much interest you pay over time. Since interest is calculated on an increasing balance (principal + accrued daily interest), frequent compounding can lead to higher total interest costs.
You should be aware of a couple of key points:
- Compounding makes a difference: Even if two loans have the same interest rate, the one with more frequent compounding will cost more over time.
- Payment deferrals and missed payments can increase costs: If a borrower defers payments or pays less than the required amount, interest continues to accrue and compounds, increasing the mortgage balance.
How the Frequency of Compounding Affects Mortgage Payments
The number of times interest is compounded each year influences the overall mortgage cost. Here’s a comparison to illustrate this point:
| Compounding Frequency | Annual Interest Rate | Effective Interest Rate (Actual Interest Paid Over a Year) |
| Annually (1x per year) | 5.00% | 5.00% |
| Semi-Annually (2x per year) | 5.00% | 5.06% |
| Monthly (12x per year) | 5.00% | 5.12% |
| Daily (365x per year) | 5.00% | 5.13% |
Although the differences may seem small, over a 30-year mortgage, these extra percentages can add up to thousands of dollars in additional interest costs.
What Can Mortgage Borrowers Do?
To minimize the effects of compounding interest and reduce the total cost of a mortgage, you should compare mortgage products. When choosing a mortgage, ask about compounding frequency. Some mortgage products may have more favourable terms.
Conclusion
Understanding mortgage compounding interest is essential for borrowers looking to manage their home loan efficiently. Since Canadian lenders compound interest semi-annually at a minimum, it’s important to factor in how this affects long-term costs. By making informed choices—such as choosing the right mortgage structure—borrowers can reduce the impact of compounding and save money over time.
