Mortgage Basics

Understanding Mortgage Principal and Interest

Understanding Mortgage Principal and Interest
Written by
  • Ashley Howard
| 27 March 2024
Reviewed, 27 March 2024
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    When purchasing a home, it is common to obtain a mortgage to cover the remaining amount after your downpayment. Each time you make a payment as scheduled, you pay off the principal and interest, collectively making up your total mortgage payment. 

    In the beginning stages of paying your mortgage, a greater portion of your scheduled payments will be allocated toward the interest, with a smaller portion allocated toward the principal. As the mortgage is gradually paid down and the principal amount decreases, the distribution of your payments will shift, with a larger portion going toward the principal and a smaller portion toward the interest until the mortgage is completely paid off.

    Key Takeaways

    • The initial amount borrowed for a mortgage is the principal, while the fee for borrowing this principal is the interest the lender charges. 
    • In Canada, mortgage interest is compounded twice a year on fixed-rate mortgages by law. 
    •  You can save time and money by altering your payment frequency.

    Understanding Mortgage Principal

    The mortgage principal refers to the initial amount borrowed from the lender, usually equal to the cost of the home minus the downpayment. Unless the downpayment is less than 20%, in which case you may choose to add the mortgage default insurance premium to your principal, the mortgage default insurance premium typically ranges from 2.8% to 4% of the borrowed amount. As regular mortgage payments are made, the principal balance will gradually decrease until the entire amount is paid off. 

    If you buy a home for $500,000 and make a downpayment of $100,000, equivalent to 20% of the total price, the remaining mortgage principal would be $400,000. On the other hand, if you only put down the minimum required amount of $25,000 or 5%, the mortgage principal would increase to $475,000. However, remember that you must also pay a mortgage default insurance premium of $19,000. This can be added to your principal amount, bringing the total principal to $494,000.

    Understanding Mortgage Interest

    The lender charges a fee for borrowing money, known as interest. This fee is expressed as a percentage and is considered the cost of doing business. It is calculated based on the outstanding principal balance and added to the mortgage principal, which you will pay as a mortgage payment. 

    Each time you pay your mortgage, a portion goes toward the principal and interest. In the case of a fixed-rate mortgage, both the principal and interest portions will stay consistent throughout the term, resulting in a fixed payment amount for the duration of the term. 

    For variable mortgages, the principal and interest components may fluctuate depending on changes to interest rates. Despite these changes, the payment amount will remain constant for the duration of the mortgage if you have a variable-rate mortgage. For adjustable-rate mortgages, the principal will remain the same, but the interest may change with changes in interest rates, potentially causing your mortgage payments to increase or decrease throughout the term.

    Understanding Mortgage Interest Compounding in Canada

    By law in Canada, all fixed mortgages must be compounded semi-annually or twice a year. In most cases, variable and adjustable mortgages are compounded monthly. Some lenders may compound the interest as frequently as your payment schedule. It’s crucial to verify the compounding period of your mortgage, as it directly impacts the overall interest charged throughout the term. 

    As compounding occurs more frequently, the interest you pay increases as it is calculated on top of interest. Any unpaid interest is included in the total balance, increasing the amount owed and the interest calculated in the next compounding cycle. Semi-annual compounding is advantageous for borrowers as it involves calculating and charging interest only twice per year. This results in lower costs than monthly compounding as less interest accumulates over the mortgage term. 

    The formula for Calculating Effective Annual Rate (EAR) on a Mortgage

    The Effective Annual Rate (EAR) is a calculation that considers the impact of compounding to give a more precise picture of the cost of a mortgage. This approach enables you to evaluate the interest rate associated with different mortgage options to make comparisons. Compounding has an impact on the actual interest rate charged and can be calculated using the following formula:

    Effective Annual Interest Rate (EAR) = (1+interest rate/n)n -1

    Where n = the number of compounding periods (2 for semi-annually, 12 for monthly)

    Using a fixed interest rate of 5%, for example, would have semi-annual compounding. You can calculate the EAR as:

    EAR = (1+0.05/2)2-1

    EAR = 0.05063 or 5.06%

    Now, using a variable interest rate of 5%, for example, would have monthly compounding. You can calculate the EAR as:

    EAR = (1+0.05/12)12-1

    EAR = 0.05116 or 5.12%

    Example of Principal and Interest for a Mortgage

    The following table shows the proportion of principal and interest paid during the life of a $500,000 mortgage with a 5% fixed rate and a 25-year amortization. 

    If the interest rate remains the same throughout the amortization and you choose to make monthly payments, you will pay more interest in the first half of the mortgage than in the second half. 

    Year Beginning Balance Interest Principal Ending Balance
    1 $500,000 $24,510 $10,386 $489,600
    2 $489,600 $23,984 $10,912 $478,700
    3 $478,700 $23,432 $11,465 $467,200
    4 $467,200 $22,851 $12,045 $455,200
    5 $455,200 $22,242 $12,655 $442,500
    6 $442,500 $21,601 $13,295 $429,200
    7 $429,200 $20,928 $13,968 $415,300
    8 $415,300 $20,221 $14,676 $400,600
    9 $400,600 $19,478 $15,418 $385,200
    10 $385,200 $18,697 $16,199 $369,000
    11 $369,000 $17,019 $17,877 $352,000
    12 $352,000 $17,016 $17,881 $334,100
    13 $334,100 $16,110 $18,786 $315,300
    14 $315,300 $15,159 $19,737 $295,600
    15 $295,600 $20,736 $14,160 $274,800
    16 $274,800 $13,110 $21,786 $253,000
    17 $253,000 $12,007 $22,889 $230,100
    18 $230,100 $10,849 $24,048 $206,100
    19 $206,100 $9,631 $25,265 $180,800
    20 $180,800 $8,352 $26,544 $154,300
    21 $154,300 $7,008 $27,888 $126,400
    22 $126,400 $5,597 $29,300 $97,100
    23 $97,100 $4,113 $30,783 $66,300
    24 $66,300 $2,555 $32,341 $34,000
    25 $34,000 $918 $33,979 $0

    Steps to Calculate Mortgage Interest

    To calculate your mortgage interest accurately, you must know your mortgage principal balance and interest rate as well as the total mortgage payment amount. This will allow you to determine the proportion of principal and interest in each payment, which will aid in accurately calculating the interest on your next mortgage payment.

    (1+i/m)m/n-1

    Where: 

    i = interest rate

    m = number of compounding periods per year

    n = number of mortgage payments made per year

    The initial monthly mortgage payment for a $500,000 fixed-rate mortgage with a 5% interest rate would include $2,061.96 of interest.

    [(1+0.05/2)2/12-1]x$500,000 = $2,061.96

    The initial bi-weekly mortgage payment for a $500,000 fixed-rate mortgage with a 5% interest rate would include $950.62 in interest. 

    [(1+0.05/2)2/26-1]x$500,000 = $950.62

    The initial weekly mortgage payment for a $500,000 fixed-rate mortgage with a 5% interest rate would include $475.08 in interest. 

    [(1+0.05/2)2/52-1]x$500,000 = $475.08

    A mortgage payment calculator is an efficient tool for determining how much of your mortgage payments will go toward interest and principal. By inputting the details of your mortgage, you can easily see the breakdown of how much is allocated to principal and interest over the term. 

    Comparison of Bi-weekly and Monthly Mortgage Payments

    By increasing the frequency of your mortgage payments, you can decrease the principal balance at a faster rate. Choosing bi-weekly payments results in 26 payments per year instead of 12 with monthly payments.

    The frequency of payments can greatly affect the interest you pay throughout your mortgage term. Making mortgage payments more often can lead to savings in interest expenses and shorten the amortization.

    Impact of Amortization on Mortgage Interest

    The amortization refers to the time needed to fully repay the mortgage through regular payments. Opting for a longer amortization means the mortgage principal will be divided over a longer time frame, resulting in lower mortgage payments. A shorter amortization will divide the mortgage principal over a shorter period, leading to higher mortgage payments.

    The duration of your amortization directly affects the amount of interest you will incur on your mortgage. With a longer amortization period, your mortgage payments are stretched out, resulting in a longer period of paying interest. As a result, the principal amount is paid off at a slower rate, and a higher amount of interest is paid.

    Given a constant interest rate for the duration of the amortization, the chart below demonstrates the effects of selecting a shorter or longer amortization period using a $500,000 mortgage with monthly payments at a 5% interest rate. The standard amortization period in Canada is typically 25 years, but opting for a shorter amortization is one way to help reduce mortgage costs.

    20-year Amortization 25-year Amortization 30-year Amortization
    20-year Amortization 25-year Amortization 30-year Amortization
    Monthly Mortgage Payment $3,285.63 $2,908.02 $2,668.45
    Total Interest $288,550.04 $372,407.48 $460,643.22
    Total Mortgage Cost (Principal and Interest) $788,550.04 $872,407.48 $960,643.22

    Changing your amortization period from 25 to 20 years will result in a $377.61 increase your monthly payments, but you will save $83,857.44 on your mortgage. Conversely, extending your amortization to 30 years will decrease your monthly payments by $239.57 but will ultimately increase your mortgage interest by $88,235.74.

    One option to decrease the amortization period is to switch to an accelerated payment frequency. This will result in slightly higher regular mortgage payments but will ultimately lead to a shorter repayment period and lower overall interest. Utilizing prepayment privileges is another effective strategy to reduce the principal balance, decrease interest payments, and accelerate paying off your mortgage.

    Frequently Asked Questions

    Do I always pay interest and principal on a mortgage?

    Mortgage payments are divided into two portions: principal and interest. Initially, more of your payments will go toward interest and less toward the principal. As you continue to pay down your mortgage balance, the amount toward interest will decrease, and the amount toward the principal will increase.

    Is my interest supposed to be higher than the principal?

    When you start making mortgage payments, the interest will be higher than the principal. Once you continue making payments and reducing the principal, your interest will decrease, and you’ll pay more than interest.

    How is my interest payment calculated?

    Interest payments are calculated based on your outstanding mortgage principal balance and the compounded interest rate. The frequency of your payments is also taken into consideration.

    Final Thoughts

    Understanding how mortgage interest is calculated can help you make sound financial decisions when selecting a mortgage and payment frequency. Familiarizing yourself with the amount of principal and interest you pay at the beginning of your mortgage can help you create a mortgage plan that can save you time and money. 

    Get in touch with our team to compare and save the best mortgage rates and terms and find the best mortgage solution for your financial goals.