Can you spot the hidden cost in your mortgage?

What does 'compounding frequency' mean?

For every mortgage, interest is calculated at intervals and added to the principal loan amount. Depending on the interval frequency, extra interest costs can notably accrue over time.

The compounding frequency affects your EAR.

Your EAR (effective annual rate) takes into account your contract mortgage rate calculated at the compound frequency.

How often your variable rate is compounded affects how much interest accumulates on your loan over time. Even with semi-annual compounding, there's a slight increase in your mortgage's EAR compared to your contract rate.

But at a higher frequency (like monthly), the interest is calculated and added to the principal balance more often. You start earning 'interest on interest' earlier, and as your mortgage term progresses, the total interest you're paying on your loan slowly increases. Despite your contract rate, your effective or real annual rate is pushed even higher.

Lenders use a higher compounding frequency to 'plump up' your rate and boost their bottom line.

Semi-annual is considered the 'fair' frequency.

Federally regulated as the standard for fixed-rate mortgages, semi-annual compounding is also considered the 'fair' frequency on variable-rate mortgages.

However, unlike a fixed mortgage 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.

When might you run into monthly compounding?

There are two types of variable-rate mortgage products: adjusting or fixed payments.

The fixed-payment kind makes up about 75% of variable-rate mortgages held in Canada. This product is only offered by big banks, and some sneak in monthly compounding to help cover their costs.

Some online-only mortgage platforms may also present a bargain-bin rate upfront but use monthly compounding (and higher pre-penalty payments) in the fine print to make up their margin.

The higher your rate, the more monthly compounding costs you.

As noted in the effective rate examples above, the higher your contract rate, the more compounding interest monthly (vs. semi-annually) adds up.

• With a 5.0% rate, you'll pay over $1,000 more for a 5-year term
• With a 6.0% rate, you'll pay over $1,400 more for a 5-year term

There's still a difference if your variable rate is lower, say 3.0% (a monthly-compounding effective rate of about 3.04%) — you'll pay around $355 extra in interest over 5 years.

Does weekly interest compounding cost even more?

Some big banks might align the interest compounding frequency with your mortgage payment schedule (e.g. monthly, biweekly, weekly) — though it's roughly the same extra cost as monthly compounding.

The biggest jump is from semi-annual to monthly, but after that, the compounding math peters out. A weekly compounding frequency adds only a nominal increase, which would only be (slightly) apparent at higher mortgage rates.

For example, a 6.0% rate compounded weekly is 6.18% vs. 6.17% for monthly compounding — a 0.01% difference.

An EAR isn't an APR.

Your EAR (effective annual rate) isn't to be confused with your APR (annual percentage rate), which calculates your total mortgage costs.

While the effective rate captures the compounding frequency for your 'real' rate of interest, an APR takes into account all your main mortgage expenses and rebates (such as contract rate, closing costs, and other fees or rebates) for a more accurate number representing all your mortgage costs boiled down to a percentage.

Your mortgage APR is listed in your mortgage commitment letter. Your EAR isn't listed in the commitment, but the compounding frequency is.

When weighing your options, you may be okay with the hidden cost.

Some clients prefer static payments for their variable-rate mortgage despite the potential downsides this product can carry:

• A higher real interest rate if monthly interest compounding is used
• Increasing amortization during times of prime-rate hikes (your amortization adjusts instead of your payments)
• Trigger rates and trigger points lurking in the mortgage fine print (a concern if rates are going up)

When rates go down, your static mortgage payments won't decrease along with rate drops, but some product downsides may become a benefit — for example, if your amortization drops below your original schedule to pay down your mortgage faster.

The apple of our (mortgage) eye.

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Salaried and unbiased, we have the independence to source your perfect fit from several lenders. And yet, we're a unified voice with sound advice that helps you see the fine print and know what you're getting with your lower rate.

Wherever you are in Canada, our apples don't fall far from the tree (all True North brokers are friendly and exceptionally trained). Apply with us online, over the phone, by email, or visit a store near you.