- Credit Card
- Real Estate
Mortgages are compounded 2 times a year in Canada and 12 times a year in the USA. However, I read that mortgages are simple interest and not compound interest because you pay the interest for each month in full, leaving nothing to compound in the next month. This seems self-contradictory and confuses me.
1) If you don’t pay the accrued interest due at the compound period, it’s clear to me that you’re going to pay interest on interest (compound interest). But with mortgages that shouldn’t be the case, so why are we using the compound interest formula:
principal * (1 + interest / compound periods per y) ^ (compound periods per y * nb yrs)
principal * (1 + interest * nb yrs)
Let’s take a loan of $1000 @ 1% amortized on 2 years and compounded yearly. If you pay the $10 after year one, and then pay again $10 after the second year, even if it was compounded twice, you end up with the same result than the simple interest formula. Why it’s different with mortgages? Why the number of compound periods is relevant if interest isn’t compounded?
2) If a mortgage is simple interest, why a nominal rate of 6% has an effective annual rate of 6.09%? I know how to find the effective rate:
(1 + (nominal interest rate / number of period)) ^ number of period - 1
… but from the amortization table is it possible to calculate the same number? I just don’t see what that number means. Will the loaner pay that effective rate? What is it?