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)
```

and not

```
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?

Using the effective interest rate calculation explained here

https://en.wikipedia.org/wiki/Effective_interest_rate#Calculation

Why is this different from the nominal rate?

Nominal rates are intended to make it easy to calculate the periodic rate, here 3% for every six months. With compounding the result is the effective rate: 6.09%.

By way of explanation of nominal versus effective rate:

“

Fractional compounding not readily available” i.e. to calculate the periodic rate from the effective rate requires a relatively more complex calculation:It is far easier to use calculate the periodic rate from the nominal rate:

However, compounding at 3% results in

`(1 + 0.03) (1 + 0.03) - 1 = 6.09%`

not`6%`

.The nominal rate is simple device to make calculation easy. The effective rate is what you get.

To calculate return the periodic rate is used. E.g. over two years

If the mortgage is on Fixed Interest Rate; the total payable is arrived at taking into account the interest compounding. So let’s start with 100 as loan for with yearly rate of 6% compounded semi annually. Total Tenor of the loan is 2 years.

For first 6 months, the interest will be 100*0.06*6/12 = 3

For the next 6 months, the interest will be 103.06*6/12 = 3.09

For the 3rd 6 months, the interest will be 106.09*0.06*6/12 = 3.1827

For the last 6 months, the interest will be 109.2727*0.06*6/12 = 3.2782

Total payable will be 112.550881

The monthly repayment will work out as 112.550881/24 = 4.6896

Thus the compounding does indicate what your monthly payment will be. As mortgages are typically over 25 or 30 year periods, this does result in better funds for Bank while showing the rate as less.

Most Mortgages are on Variable Rate of Interest. In such case the computation is different and would not use the above methodology; it would be the rate applied on the outstanding amount. The EMI would pay off the interest.

On a pure Simple interest loan, the calculations will be as indicated by you.