Canadians are changing their preferences for mortgages. With a recent decrease in interest rates and speculation that more could be coming, brokers have been advising their clients to return to variable-rate mortgages from the 5-year fixed mortgages that have been the most popular recently.
However, not all variable mortgages are calculated the same. Some variable-rate mortgages calculate mortgage interest monthly, while other variable-rate mortgages calculate mortgage interest semi-annually. Without knowing how your variable rate mortgage is being calculated, you can’t compare mortgages based on interest rate alone.
Understanding interest calculation frequency impacts the amount you pay overtime because the compounding frequency (semi-annual) doesn’t align precisely with the frequency of interest rate adjustments (monthly). As a result, the compound interest calculations might not reflect the most recent interest rate changes immediately but only at the end of each six months.
It is important to understand the differences so you can align your mortgage strategy with your mortgage product.
Canadians Historically Prefer Variable Rate Mortgages
Variable All Rate Mortgages Are Calculated the Same
Is Monthly or Semi-Annual Calculation Better?
Canadians Historically Prefer Variable Rate Mortgages
Canadians have historically shown a preference for variable-rate mortgages over fixed-rate mortgages for several reasons, including financial benefits and market trends. Here’s a breakdown of the key factors:
- Lower Initial Rates: Variable-rate mortgages often start with lower interest rates compared to fixed-rate mortgages. This can make them more attractive, especially for buyers looking to minimize their initial payments.
- Potential for Interest Savings: Over time, if interest rates decrease or remain stable, those with variable-rate mortgages can end up paying significantly less interest compared to those locked into a higher fixed rate. Historical data in Canada has shown that variable rates tend to be cheaper over the long term.
- Flexibility: Variable-rate mortgages usually offer more flexibility. They often come with lower prepayment penalties than fixed-rate mortgages, making them more appealing to homeowners who might consider selling their home or refinancing their mortgage before the term is up.
- Market Trends and Economic Predictions: When the economic outlook predicts stable or falling interest rates, homeowners might be more inclined to opt for a variable rate, anticipating that rates will stay the same or decrease, leading to savings on interest payments.
- Financial Strategy: Some homeowners are comfortable with the risk of rate fluctuations and are financially prepared to handle potential increases in interest rates. They might prefer the variable rate option as part of a larger financial strategy, betting that the flexibility and potential for lower costs will outweigh the risks.
- Historical Success: Studies and financial analyses in Canada have often shown that, historically, homeowners with variable-rate mortgages have paid less interest compared to those with fixed-rate mortgages. This historical success has reinforced the preference for variable-rate mortgages among new borrowers.
Each of these factors plays into the decision-making process for Canadian homeowners, contributing to the popularity of variable-rate mortgages, especially during periods when interest rates are expected to remain stable or decline.
Variable All Rate Mortgages Are Calculated the Same
Not all variable rate mortgages are calculated the same. Particularly, the interest rate calculation can differ from one variable rate mortgage to another. Some variable rate mortgages are calculated using a monthly interest rate calculation while others are calculated using semi-annual compounding. This means that while the interest rate adjusts based on the prime rate changes, the calculation of the interest on the outstanding balance of the mortgage happens twice a year. This compounding effect can influence the overall amount of interest paid over the life of the mortgage. This difference can result in a substantial difference in what a borrower pays in terms of mortgage interest.
Let me simplify the explanation about how a variable rate mortgage that calculates interest monthly but compounds it semi-annually works in Canada.
Key Concepts:
- Monthly Interest Calculation: Each month, the interest due is calculated based on the current balance of the mortgage and the prevailing interest rate, which can change monthly with the prime rate. This means your payment could be different each month, depending on rate fluctuations.
- Semi-Annual Compounding: Although the interest is calculated monthly, the compounding—the process of adding the accumulated interest to the principal amount—happens only twice a year. Compounding affects how much total interest you’ll pay over the life of the mortgage.
Step-by-Step Example:
Initial Setup:
- Mortgage Principal: $300,000
- Annual Interest Rate (initially): 3.2%
Monthly Interest Rate:
- Annual rate divided by 12: 3.2% / 12=0.267% per month
Monthly Calculation:
- For January: $300,000 times 0.267% = $801
This $801 is the interest for January alone.
Compounding Frequency:
- Even though $801 of interest is calculated in January, this interest does not get added to the principal immediately for the purposes of calculating future interest. This only happens semi-annually.
Mid-Year Update:
- Suppose in July, the interest rate increases to 3.5% per year or about 0.292% per month.
- If we calculate interest monthly but haven’t compounded yet, we continue to apply the new rate to the original principal for monthly calculations until compounding occurs.
First Compounding (end of June):
- Let’s assume the interest for the first six months at various rates (assuming some changes) totals about $4,800.
- At the end of June, this $4,800 is added to the original principal. So now the principal for July calculations is $304,800.
Continued Calculations:
- For July, using the new rate on the new principal: $304,800 times 0.292 % = $890
- This process repeats with interest calculated monthly and the total interest for the next six months being added to the principal at the end of December.
In this system, the actual compounding (where you start paying interest on previously accumulated interest) only occurs twice a year, even though the calculation of how much interest you owe each month can change based on the mortgage rate at that time. This semi-annual compounding can lead to different long-term cost implications compared to more frequent compounding intervals.
Is Monthly or Semi-Annual Calculation Better?
When comparing the cost implications of interest rates being calculated monthly versus semi-annually on a variable-rate mortgage, the differences in total interest paid over the life of the mortgage can vary depending on the movement of interest rates:
Interest Calculated Monthly
- Responsive to Rate Changes: Monthly calculation of interest means the mortgage responds quicker to changes in the underlying interest rates, whether those rates are going up or down.
- Potential for Higher or Lower Costs: If interest rates decrease, the borrower benefits immediately each month from the reduced interest charge, potentially saving money compared to a semi-annual calculation. Conversely, if rates increase, the borrower will see an increase in interest charges more quickly.
Interest Calculated Semi-Annually
- Less Frequent Adjustments: With semi-annual calculations, changes in the interest rate are only reflected in the mortgage calculations twice a year. This can mean slower responses to both increases and decreases in interest rates.
- Potential Buffer Against Rate Hikes: When rates rise, a semi-annual calculation provides a temporary buffer against immediate increases in interest costs, which could be beneficial in a rising rate environment. However, this also means slower benefits from rate cuts.
Cost Implications
- Variable Rate Movements: The overall cost-effectiveness of monthly versus semi-annual interest calculations on a variable rate mortgage largely depends on how interest rates move over time. If interest rates are generally falling or expected to fall, monthly calculations can be more advantageous as they allow the borrower to take advantage of lower rates immediately.
- Interest Rate Volatility: In a volatile rate environment, monthly calculations can result in more pronounced swings in payment amounts, which might not be ideal for all borrowers, especially those who prefer predictable payments.
Example Scenario
Imagine a scenario where interest rates are decreasing steadily:
Monthly Calculation: Borrowers benefit immediately from each reduction in rates, paying less interest each month as rates go down.
Semi-Annually Calculation: The reduction in rates is only applied to the calculation of interest every six months, delaying the benefit from lower rates and potentially costing more in interest compared to monthly calculations during the period before adjustment.
READ MORE
Fixed vs Variable: Doing the Math
Adjustable vs Variable Mortgages
Is Fixed or Variable Best for YOU?
Variable Rate Mortgage Strategy
Summary
It isn’t universally cheaper or more expensive to have interest calculated monthly versus semi-annually; it depends on the direction and volatility of interest rates. Monthly calculations provide quicker adjustments to both increases and decreases in rates, which can be a double-edged sword, offering both rapid benefits during decreases and quicker cost increases during rises. Semi-annual calculations, while less responsive, offer more payment stability over each six-month period.
Fundamentally, it all depends on how aggressive your mortgage strategy is. If you are willing to take on more risk to be able to pay down your mortgage faster, you want to choose a variable-rate mortgage that compounds interest monthly. On the other hand, if you want to be aligned to movements in interest rates through a variable rate mortgage but prefer a more defensive posture, then choose a variable rate mortgage that compounds semi-annually so changes to interest rates aren’t reflected in your payments immediately.
