As a mortgage broker, one of the most common questions first time home buyers as-is: “How do mortgage interest rates work”?. The truth is that many Canadians don’t truly understand how interest works. This fact isn’t surprising as personal finance receives a backseat to most subjects taught in public school. This article will teach you how mortgage interest rates work and help you make some very important decisions about your financial future.

What is Interest?Scrabble letters spelling mortgage

Interest is simply the fee charged by one party lending money to another party. If you’ve ever placed your money in a savings account, you’ve actually made a short-term loan to the bank and they pay you interest (albeit not much) each month for lending them your money. 

Why do banks pay you interest on a savings account?

The bank doesn’t let your money sit in the account and pay you for the privilege. Instead, they take a portion of your money and lend it out on other higher interest loans such as credit cards and lines of credit, and earn a profit between what they earn from the loan and what they pay you for your deposit.

How Do Mortgage Payments Work?

Before discussing how a mortgage interest rate works, we need to know a little about how a mortgage payment works. A mortgage is an amortized loan, which is a fancy way of saying that the loan is paid back over a set period of time. With each payment you make, you pay part interest (the fee for borrowing the money) and part principal (the money you borrowed) to the lender.

Breakdown of a mortgage payment into principal and interest

 

For example, if you have a $500,000 mortgage and you are paying it back over 25 years at 2.49%, you will have a monthly payment of $2,237.34. During your first payment, your monthly payment contains $1,205 of principal and $1,032 of interest. Therefore, after your first payment, you now only owe $500,000 – $1,205 or $498,795. 

 

Here is where it gets tricky. 

After your first monthly payment, you now owe the lender less money. You have 24 years and 11 months remaining on your loan, but your payment is still $2,237.34 and your rate is still 2.49%. Now your 2.49% interest rate is calculated against the lower remaining balance. Since the outstanding balance is lower, you owe less interest when making your next payment. So for your second payment, your monthly payment consists of $1,208 of principal and only $1,029 of interest. 

Why Do Mortgage Interest Rates Matter?Neighbourhood of rooftops

When choosing a mortgage interest rate, you will be offered many different options. Is your mortgage default insured or not? Is the home price under or over $1M? Fixed versus variable? 3-year term versus 5-year term? Home equity line of credit or not?

With the many confusing options available comes an array of corresponding interest rates. You may have two options in front of you, one a 2.49% fixed for 5 years and the other a 1.35% variable for 5 years. Your mortgage broker will tell you that the fixed gives you more stability while the variable may go up and down with changes in the Bank’s “Prime” interest rate. You may not understand these differences, however, there are two factors that you can immediately understand: monthly payment and equity.

How Do Mortgage Interest Rates Affect Payments?

This one is simple. The lower your interest rate, the lower your monthly payment. It’s that simple. In the example above, if you had a 1.35% variable interest rate, your monthly payment would actually be $1,963.76 or a monthly savings of $273.58 per month!

How Do Mortgage Interest Rates Affect Equity?

Equity is the portion of the property’s value that would be returned after selling your home. Simply: Home value – the sum of all home loans = equity. If you bought the house for $600,000 and the outstanding mortgage is $500,000, you have $100,000 in home equity. If you pay down the mortgage by $50,000 and the value of the property rises another $50,000, you now have $200,000 of equity.

How do mortgage interest rates affect equity? The lower the interest rate, the faster you build equity by paying down your outstanding loan.

Let’s look at our previous example at a lower mortgage interest rate. At a rate of 1.35%, your first monthly payment contains $1,403 of equity ($195 more than @ 2.49%) and only $561 of interest (almost 50% less than the previous example). 

 

Office supplies and a cactus sitting on a white tableWhy is Equity Important?

Think of your home equity as a savings account. If you need money and there is equity in your home, you can take out another loan against the property at a lower cost than other types of credit. Alternatively, you can sell the property and take the proceeds as cash. 

When thinking about your home equity like a savings account, your monthly mortgage becomes a savings plan. If you want to build your savings faster, a lower interest rate will help you put more money into savings each month, since a larger portion of your payment goes towards principal versus a higher mortgage rate.

Summary

If you’re planning to buy a home or thinking of refinancing your mortgage, interest rates will impact how much you pay and how fast you build equity. Although the lowest interest rate is typically most beneficial, there are tricks to watch out for as mortgages are about more than just interest rates. Consult a knowledgeable mortgage broker for a better understanding of what rate best fits your personal financial situation and to ensure that you receive the best rate available for the product that best fits your needs.

About the Author

The column's goal is to level up your financial knowledge and help you avoid common pitfalls and mistakes along the way. Although money management sometimes seems like an intricate task, it doesn't have to be. The advice here is common sense and simple to follow. The first step to a better financial future starts here, and it's never too late to begin. Adam Stapley is a Mortgage Broker with Pineapple Financial and author of the personal finance blog CanadianFinanceGuide.ca. He is intensely passionate about helping Canadians build wealth through the power of real estate. Many of the articles in this column come from Adam's experience assisting Canadians to understand and shape their personal finances. Pineapple Financial Lic #12830 CanadianFinanceGuide.ca adam@canadianfinanceguide.ca