How Does Mortgage Interest Work?
Mortgage interest is a fee you pay to a mortgage lender for the use of their money. Every mortgage payment you make will include at least some interest.
If you have a fixed-rate mortgage, the interest payments will be set for the length of your mortgage’s term. If you have a variable-rate mortgage, they could change.
Regardless of your mortgage type, the main takeaway for borrowers is universal: The interest you pay on a mortgage can easily be as much as the cost of the home itself. Knowing how interest works is a crucial step to understanding how much mortgage you can afford.
How mortgage interest rates are set
The mortgage rate you’re offered by a lender is specific to you and based on many factors.
Some factors — including your credit score, income and employment history — are under your control. Other factors, like government bond yields and your lender's prime interest rate, are determined by investors and the Bank of Canada.
How fixed rates work
Your mortgage principal — the amount you borrow — starts accruing interest at your agreed-upon rate as soon as the loan closes. The process works similarly to how you earn interest on deposits in a savings account except, in this case, you pay the bank interest instead of the bank paying you.
When it’s time to make your first mortgage payment, the interest is paid first. The remainder of the payment goes toward the principal.
The cycle begins again. However, now the beginning principal is slightly smaller than when your mortgage began, thanks to the portion of last month’s payment that paid down the principal. As a result, the amount of interest that accrues when next month’s payment is due will be slightly less than last month’s payment, and the percentage of that payment going toward your principal will be slightly larger.
The cycle continues. With a fixed mortgage, your interest rate — and mortgage payment — stays the same for your entire term, even though the amount allocated toward interest changes over time.
If you use a mortgage payment calculator online, be sure it’s built for Canadians. In Canada, interest is compounded semi-annually; in the U.S. it’s not. You’re not going to get accurate numbers if you use a U.S. calculator.
Mortgage interest example
To visualize how mortgage interest works, look at an amortization table. Don’t let its wonky name intimidate you. An amortization table is simply a monthly breakdown of where your money goes each time you make a mortgage payment — and how many payments it will take to repay it completely.
Consider the following home-purchase scenario:
Home value: $350,000.
Down payment: $70,000 (20%).
Value of loan: $280,000.
Interest rate: 5%.
Amortization period (the time it’ll take to pay off your loan completely): 25 years.
Monthly mortgage payment: $1,628.49.
Total mortgage payments: 300.
The table below shows the first three and the final three monthly payments. For each payment, you can see the outstanding principal at the beginning of each month, followed by a breakdown of how the $1,628.49 monthly payment is divided between interest and principal repayment.
Principal amount | Interest payment | Principal repayment | Remaining principal | |
|---|---|---|---|---|
Month 1 | $280,000 | $1,154.70 | $473.80 | $279,526.20 |
Month 2 | $279,526.20 | $1,152.74 | $475.75 | $279,050.45 |
Month 3 | $279,050.45 | $1,150.78 | $477.71 | $278,572.74 |
Month 298 | $4,845.46 | $1,608.51 | $19.98 | $3,236.95 |
Month 299 | $3,236.95 | $1,615.15 | $13.35 | $1,621.81 |
Month 300 | $1,621.81 | $1,621.81 | $6.69 | $0 |
In the above example, the borrower would pay $208,548.19 in interest over the entire mortgage. Including the beginning principal of $280,000, the total amount paid would be $488,548.19.
In reality, your interest rate will likely change each time your mortgage term expires and you renew your mortgage, so the projected amount of interest you’ll pay will adjust a few times during the course of your mortgage.
How variable rates work
The fundamentals of mortgage interests are the same for a variable-rate mortgage — a portion of each mortgage payment goes toward interest and the rest goes toward the principal.
The difference is that while fixed rates are locked for the duration of the term, variable rates can rise or fall multiple times during your term. As a general rule, if your lender's prime rate changes, your mortgage interest rate will change with it.
Because of this uncertainty, a variable-rate mortgage doesn’t come with an amortization table showing a steady decline in interest payments each month. The portion of a mortgage payment going toward interest could be more than the month prior. In some instances, your mortgage payment itself could increase.
How to get a lower mortgage interest rate
It’s tempting to look at how much house you could have afforded in 2021 or talk about what interest rates will do in the future, but doing that won’t save you a single dollar in mortgage payments. Instead, the best way to get the lowest mortgage rates is to stay focused on the factors under your control.
Negotiate. Contact a few different lenders to see what rates they’re offering. Once you have a few in hand, see if any of the lenders can beat the lowest rate you first received.
Use a mortgage broker. A mortgage broker negotiates rates on your behalf — a huge plus if you’re not into doing that yourself. They also have a deep list of contacts, some of which you might not be aware of.
Strengthen your credit score. Until you submit your mortgage application, you can keep working on your credit. Pay your bills, pay down debt and don’t apply for other credit products, like credit cards. You may see changes reflected in your score in as little as 30 days, according to Equifax, a credit reporting agency.
When getting a mortgage, many people focus on getting the lowest interest rate possible, but that shouldn’t be your only priority. Be sure to check all the terms, including any prepayment penalties, before you commit.
DIVE EVEN DEEPER
Clay Jarvis