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Published August 5, 2022

How Does Mortgage Interest Work?

Mortgage interest is the fee you pay a lender to use their money. Part of your payment goes to interest and the rest goes towards the principal.

When it comes to mortgages, it’s easy to know what your monthly payments are, but understanding the details of mortgage interest can be a bit technical. Fortunately, a mortgage calculator can help you out. That said, it’s still a good idea to know the basics of mortgage interest.

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What is mortgage interest?

Mortgage interest is a fee you pay to a lender for the use of their money. When you first start making mortgage payments, most of your funds go toward interest. Then, as you approach the end of your mortgage, much of the money is applied toward the principal loan.

Every lender has different interest rate options. For example, you can choose between a fixed rate or a variable rate when you get a mortgage. With fixed-rate mortgages, your interest rate doesn’t change during the term of the mortgage. On the other hand, variable-rate mortgages can fluctuate.

When your mortgage is up for renewal, you will renegotiate the term and interest rate.

How are mortgage rates set?

The prime interest rate set by the Bank of Canada is arguably the most important factor that determines mortgage interest rates. This number is used by lenders to set their posted interest rates and can change frequently.

Some additional criteria may affect interest rates, including:

  • Your mortgage term. Generally, the shorter your mortgage term, the better rates you’ll get.
  • Your credit history. If you have a good credit score, you’ll usually qualify for the lowest rates.
  • The type of mortgage you choose. Fixed and variable mortgages have different interest rates.
  • How much you can negotiate. Rarely do people pay the posted rate. You can usually negotiate a discounted rate.
  • Your employment history. If you’re self-employed or recently changed jobs, you may not get access to the lowest rates.

Types of mortgage rates

As weird as it sounds, there are actually different types of mortgage rates that may affect you in some ways.

  • Prime rate. Known as the prime lending rate, or overnight rate, this rate is set by the Bank of Canada and used by financial institutions to set interest rates for loans.
  • Posted rate. These rates are what lenders publicly announce. They’re used mainly to calculate interest rate differential (IRD) if you break your mortgage.
  • Discounted rate. This is the actual interest rate you pay when getting a mortgage.

What many homeowners don’t realize is that the posted rate is just a sticker price. Sure, you could get a mortgage for that amount right away, but why would you do that when you can negotiate a discounted rate instead?

Many financial institutions are banking on the fact that you may not be aware that discounts are available or you’re too lazy to shop around. However, as a consumer, it’s in your best interest to negotiate your mortgage rate since it could save you thousands of dollars.

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How mortgage rates are calculated

An online mortgage payment calculator will allow you to quickly calculate what your payments will look like. Other calculators can help you determine what size mortgage is affordable or how different amortization periods affect your payments. The info you’ll need is as follows:

Fixed-rate mortgages are compounded semi-annually. That means that the rate you’re quoted is a bit lower than what you’ll actually pay once you factor in compound interest. For example, a fixed-rate mortgage of 6% has an effective annual rate of 6.09%.

With variable mortgages, you make the same payment every month. However, if rates fluctuate, so does the interest portion of your payments. When interest rates rise, more of your payments go toward interest. On the other hand, when rates fall, you’re making larger payments toward the principal. That means you’re paying off your mortgage faster.

How to get a lower mortgage interest rate

Even though mortgage interest rates are posted at every financial institution, there are many ways to lower your rate.

  • Ask for a discounted rate. Every lender can provide a discount. You just need to ask and negotiate.
  • Shop around. You’ll want to contact a few different lenders to see what rates they’re offering.
  • Choose a variable rate. Variable-rate mortgages are usually lower than fixed-rate mortgages, but they could go up during your term.
  • Use a mortgage broker. Working with a broker can be beneficial since they can shop around and find you the lowest rate.
    Refinance. If you already have a mortgage, you could see if your lender allows you to blend and extend your mortgage.

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 options, before you commit.

About the Author

Barry Choi

Barry Choi is a freelance personal finance and travel expert. His website is one of Canada's most trusted sites when it comes to all things related to money and…

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