How to calculate monthly mortgage principal and interest

When you make a mortgage payment, you are paying towards both your principal and interest. Your regular mortgage payments will stay the same for the entire length of your term, but the portions that go towards your principal balance or the interest will change over time.

As your principal payments lower your principal balance, your mortgage will become smaller and smaller over time. A smaller principal balance will result in less interest being charged. However, since your monthly mortgage payment stays the same, this means that the amount being paid towards your principal will become larger and larger over time. This is why your initial monthly payment will have a larger proportion going towards interest compared to the interest payment near the end of your mortgage term.

This behaviour can change depending on your mortgage type. Fixed-rate mortgages have an interest rate that does not change. Your principal will be paid off at an increasingly faster rate as your term progresses.

On the other hand, variable-rate mortgages have a mortgage interest rate that can change. While the monthly mortgage payment for a variable-rate mortgage does not change, the portion going towards interest will change. If interest rates rise, more of your mortgage payment will go towards interest. This will reduce the amount of principal that is being paid. This will cause your mortgage to be paid off slower than scheduled. If rates decrease, your mortgage will be paid off faster.

What is a Mortgage Principal?

A principal is the original amount of a loan or investment. Interest is then charged on the principal for a loan, while an investor might earn money based on the principal that they invested. When looking at mortgages, the mortgage principal is the amount of money that you owe and will need to pay back. For example, perhaps you bought a home for $500,000 after closing costs and made a down payment of $100,000. You will only need to borrow $400,000 from a bank or mortgage lender in order to finance the purchase of the home. This means that when you get a mortgage and borrow $400,000, your mortgage principal will be $400,000.

Your mortgage principal balance is the amount that you still owe and will need to pay back. As you make mortgage payments, your principal balance will decrease. The amount of interest that you pay will depend on your principal balance. A higher principal balance means that you’ll be paying more mortgage interest compared to a lower principal balance, assuming the mortgage interest rate is the same.

What is Mortgage Interest?

Interest is charged by lenders in exchange for allowing you to borrow money. For borrowers, mortgage interest is charged based on your mortgage principal balance. The mortgage interest charged is included in your regular mortgage payments. This means that with every mortgage payment, you will be paying both your mortgage principal and your mortgage interest.

Your regular mortgage payment amount is set by your lender so that you’ll be able to pay off your mortgage on time based on your selected amortization period. This is why your mortgage payment amount can change when you renew your mortgage or refinance your mortgage. This can change your mortgage rate, which will impact the amount of mortgage interest due. If you now have a higher mortgage rate, your mortgage payment will be higher to account for the higher interest charges. If you’re borrowing a larger amount of money, your mortgage payment may also be higher due to interest being charged on a larger principal balance.

However, mortgage interest isn’t the only cost that you’ll need to pay. Your mortgage might have other costs and fees, such as set-up fees or appraisal fees, that are necessary to get your mortgage. Since you’ll need to pay these extra costs in order to borrow money, they can increase the actual cost of your mortgage. That’s why it can be a better idea to compare lenders based on their annual percentage rate (APR). A mortgage’s APR reflects the true cost of borrowing for your mortgage. You can use an APR calculator, or you can manually calculate your mortgage’s APR using the total interest paid, fees paid, and the loan term length.

Mortgage Interest Compounding in Canada

Mortgage interest in Canada is compounded semi-annually. This means that while you might be making monthly mortgage payments, your mortgage interest will only be compounded twice a year. Semi-annual compounding saves you money compared to monthly compounding. That’s because interest will be charged on top of your interest less often, giving interest less room to grow.

To see how this works, let’s first look at credit cards. Not all credit cards in Canada charge compound interest, but for those that do, they usually are compounded monthly. The unpaid interest is added to the credit card balance, which will then be charged interest if it continues to be unpaid. For example, you purchased an item for $1,000 and charged it to your credit card which has an interest rate of 20%. You decide not to pay it off and make no payments. To simplify, assume that there is no minimum required payment.

To calculate the interest charged, you’ll need to find the daily interest rate. 20% divided by 365 days gives a daily interest rate of 0.0548%. For a 30-day period, you’ll be charged $16.44 interest. Interest is calculated daily but only added once a month. Since you’re not making any payments and are still carrying a balance, your credit card balance for the following month will be $1016.44. As the interest is added to your balance, this means that interest is being charged on top of your existing interest charges. For another 30-day period, you’ll be charged $16.71 interest, which now makes your credit card balance $1,033.15.

The same applies to mortgages, but instead of monthly compounding, the compounding period for mortgages in Canada is semi-annually. Instead of adding unpaid interest to your balance every month like a credit card, a mortgage lender is limited to adding unpaid interest to your mortgage balance twice a year. In other words, this affects your actual interest rate based on the interest being charged.

Mortgage Effective Annual Rate Formula (EAR)

To account for semi-annual compounding, you can calculate your mortgage’s effective annual rate (EAR). The number of compounding periods in a year is two. To use the effective annual rate formula below, convert your interest rate from a percent into decimals.

Mortgage Effective Annual Rate =( 1 +)2 - 1

For example, if your mortgage lender quotes a mortgage rate of 3%, then your effective annual rate will be:

( 1 +)2 - 1 = 0.030225 = 3.0225%

If your mortgage lender quotes a mortgage rate of 5%, then your effective annual rate will be:

( 1 +)2 - 1 = 0.050625 = 5.0625%

This calculation assumes that interest will be compounded semi-annually, which is the law for mortgages in Canada. For a more general formula for EAR:

Effective Annual Rate =( 1 +)n - 1

Where “n” is the number of compounding periods in a year. For example, if interest is being compounded monthly, then “n” will be 12. If interest is only compounded once a year, then “n” will be 1.

How Does Amortization Affect Mortgage Interest?

Your amortization period is the length of time that it will take for you to pay off your mortgage fully if you only make your required regularly scheduled mortgage payments. The longer you owe money, the more time there is for interest to be charged. That’s why a longer amortization period will result in a higher total interest paid compared to a shorter amortization period. On the other hand, a shorter amortization requires larger mortgage payments in order to pay off the mortgage faster. While this will save you money, you will need to be able to afford these larger payments.

In Canada, the most common amortization period is 25 years. Coincidently, it’s also the maximum amortization limit allowed for insured mortgages, such as mortgages that have CMHC insurance. However, you can always choose to have a shorter or longer amortization period. How will your amortization affect your mortgage interest?

Let’s take a look at a mortgage with a principal balance of $500,000 and a fixed mortgage rate of 2.50%. We will compare 15-year, 20-year, 25-year, and 30-year amortizations to see how much interest you will have to pay over the lifetime of your mortgage loan.

If you chose a 20-year amortization instead of 25-years, you will need to pay an extra $406 every month but you will save $37,042 in interest over 20 years. If you paid an extra $1,091 every month for a 15-year amortization, you’ll save a total of $72,815 in interest. If you want to lower your mortgage payments and choose to get a 30-year amortization instead, you’ll save $268 per month through lower payments but end up paying $38,293 more in interest.

The interest vs. principal ratio also gives us a look at how each option compares. With a 30-year amortization, you’ll be paying 42.2% on your mortgage balance in interest. Choosing a 15-year amortization can slash this ratio in more than half, to just 20%. Of course, the above calculations assume that you will not be making any extra payments and that your mortgage rate is fixed at 2.50%. The numbers will change depending on your actual interest rates, but the positions of each option will not.

Breakdown of Mortgage Payments

It’s important to understand your mortgage payment structure so that you can find ways to save money. Let's take a look at mortgage payments and their payment breakdowns.

Your mortgage principal balance and your mortgage interest will change during your mortgage term, but something that doesn't change is your monthly payment amount. Your selected amortization period determines your monthly payment amount which will be fixed for the duration of your term. When you first get a mortgage, most of your monthly payment will go towards interest. You haven’t had time to pay down your mortgage balance yet, and so when interest is charged, you’ll need to pay interest on a higher mortgage balance.

As time passes by and your balance decreases, there is less balance remaining for interest to be charged. This reduces the proportion of interest charged compared to your monthly payment. The amount remaining can then go towards paying down your mortgage balance further. This is similar to compound interest but in reverse.

Effects of Amortization on Mortgage Interest

• Mortgage Principal Balance: $500,000
• Mortgage Rate: 2.50% fixed for the entire amortization

This is one reason why making mortgage prepayments is so important if you want to save money. Banks and mortgage lenders usually allow you to make mortgage prepayments up to a certain limit every year for closed mortgages. For example, RBC lets you make prepayments up to 10% of your principal every year, while the limit with TD is 15%. You can make prepayments without prepayment penalties if you stay under their annual limits.

Mortgage prepayments are payments that go directly towards paying down your principal balance. Making prepayments can also allow you to pay off your mortgage ahead of schedule. This saves you money and makes you one step closer to becoming mortgage-free.

The calculators and content on this page are provided for general information purposes only. WOWA does not guarantee the accuracy of information shown and is not responsible for any consequences of the use of the calculator.

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What is the formula for calculating principal and interest?