Compound Interest & Mortgages

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?

2 thoughts on “Compound Interest & Mortgages

  1. Chris Degnen

    Using the effective interest rate calculation explained here

    i = 6% nominal interest compounded twice annually
    n = 2 compounding periods per annum
    r = (1 + i/n)^n - 1 = (1 + 0.06/2)^2 - 1 = 6.09%

    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:

    The “Truth in Lending Act” passed in 1968 did not incorporate the
    mathematically-true annual percentage rate, because the true
    calculation used compounding (sometime fraction compounding), which
    was not readily available. The result on expression of the APR on
    credit cards uses a Nominal (simple interest) method … which can far
    from the truth. The Truth in Lending Act should be changed to the
    mathematically-true (EFFECTIVE) APR from the untrue (NOMINAL) APR,
    merely by changing the word in act from “multiplied by” to “compounded

    Fractional compounding not readily available” i.e. to calculate the periodic rate from the effective rate requires a relatively more complex calculation:

    periodic rate = (1 + r)^(1/n) - 1 = (1 + 0.0609)^(1/2) - 1 = 3%

    It is far easier to use calculate the periodic rate from the nominal rate:

    periodic rate = i/n = 0.06/2 = 3%

    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

    nominal rate compounded twice annually = 6%
    periodic rate, pr = 3%
    number of periods, np = 4
    return = (1 + pr)^np - 1 = (1 + 0.03)^4 - 1 = 12.5509%
  2. Dheer

    If a mortgage is simple interest, why a nominal rate of 6% has an effective annual rate of 6.09%? In other words, why are we doing

    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.

    I’m reading everywhere that mortgages are not compounded because the accrued interest is always paid before

    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.

    if a mortgage is simple interest,

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

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