Monday, 6 July 2015

The Dirty Secret Your Variable Rate Mortgage Might Be Hiding...

Are you aware that your variable rate mortgage might have a dirty little secret? And that it could cost you a significant amount of money? Taking the time to review and understand all your mortgage details can make the difference between thinking you are getting the best rate and knowing you are getting the best rate.

The Secret

Does anyone remember way back in school when they taught us about compounding and interest? While I for one definitely slept through that class, it would have been a valuable lesson to learn early.

Compounding is essentially the number of times per year that your interest owing is calculated. There are many different methods of calculating interest, but for the sake of this article we will keep things simple. In the world of Canadian mortgages, most are either compounded Semi-Annually(i.e. Twice per year), or Monthy(once each month). While fixed-rate mortgages are required by law to always be calculated on a semi-annual basis, lenders are free to choose their calculation of choice when it comes to variable rates. This means that your variable rate mortgage could use either calculation, depending on your lender's preference.

Is My Mortgage Keeping Secrets From Me?

In all likelihood there could be several things you should know about your mortgage that you may not be aware of. These could be things like the compounding period for interest, prepayment privileges, penalties, fees, and the type of registration(i.e. Collateral Charge). While I discuss these details at length in other articles(click the links to check out some other articles), today we will focus on your compounding period.

When it all boils down to it, what you need to know is this:

If your lender uses monthly compounding, it will cost you more than a comparable rate compounded semi-annually.

What Could This Cost Me?

As an example, let's compare 2 mortgages. Both have a starting balance of $300,000, and an interest rate of 5%. The only difference between these 2 is that one uses monthly compounding and the other uses semi-annual.

 Monthly Compounding

Semi-Annual Compounding

What you will notice is that the monthly compounding option costs a whopping $7314.93 over the life of your mortgage. Even if you break that down, it will cost you an extra $755.27 over a 5-year term. This is because the more frequent compounding forces you to pay more interest during each calculation. The difference between the 2 rates can be best demonstrated by comparing the Effective Annual Rate for each, as if it were calculated only once per year.

5%, compounded monthly = EAR of 5.1162%
5%, compounded semi-annually = EAR of 5.0625%

As you can see, as the compounding frequency increases, so too does your cost of borrowing. And while this information is required to be disclosed to borrowers, most people don't receive it until late in the mortgage process when it will be of little use for comparison. 

What Do I Do About It?

Always trust a mortgage professional to review the details of any mortgage you are considering. Ask lots of questions and don't be afraid to make sure you are aware of all the details up front. Something like compounding could mean thousands of dollars in extra costs and/or an unfair comparison between 2 lenders. A good mortgage broker can show you the differences like this between lenders so that you are making an informed decision that is right for you.

Do you feel like some of the details of your mortgage are unclear? Contact Ryan for a free consultation and we can review the details and make sure that you understand and are satisfied with your current lender and product. If not, then continue to follow us here and at for more info on mortgages, real estate, and personal finance.

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