The ABCs of a mortgage
A) How much to borrow (principal).
B) The Annual Interest Rate that’s offered or available (AIR in Canada, called the APR in the USA).
C) How long to borrow the money (amortization period, called the term in the USA).
Once you decide/select the first three items (a,b,c) the payment is the only item remaining to calculate. You cannot specify a monthly payment if a, b and c have been specified. Your calculated payment depends upon a,b,c and also items d and e, which are usually dictated by your lender;
D) Type of “compounding”
E) Days per year (360 day year aka Bankers year or a 365 day year)
F) Before the payment is calculated you must decide if its to be monthly, weekly or biweekly (Canadians have this flexibility at all major lending institutions).
G) In Canada, at this point, there are two ways of calculating the payment. 1. The standard Canadian mortgage (“semi-annual compounding”) or 2. a non collateral mortgage with “monthly compounding”. In the USA most mortgages are based upon “monthly compounding” with monthly payments.
The word “compounding” does not mean the interest you pay is compounded. You pay simple interest on your mortgage, unless you miss a payment. The type of “compounding”, describes how your payments will grow for your lender because your lender is assumed to reinvest your payments as they are received. The type of “compounding” also determines the numerical value of the interest factor, which is used at the end of each month, week or biweekly period to calculate the interest you owe the lender for the use of their money.
H) Once the payment is calculated, a repayment schedule which is also known as an amortization schedule is the next logical step.
An amortization schedule is of paramount importance because it verifies the interest factor on the first line of the amortization schedule. The larger the interest factor the larger the interest you pay for the use of the lenders money. The interest factor is the most important piece of information in your amortization schedule.
The interest portion of a blended monthly payment for a $100,000 Canadian mortgage at 12% is $975.88 therefore the monthly interest factor is 975.88/100,000 = 0.0097588 and its constant each month. An American monthly interest factor (because of “monthly compounding”), for the same mortgage, the interest factor would be 0.01 thus the interest portion of the very first payment is $1000 (0.01 x 100,000 = 1000) for the American mortgage.
All financial calculators are based upon algebraic equations that assume the year is divided into integer values. In other words, financial calculators are hard wired so the year is divided into 12 equal months. However we know not all monthly periods are equal. Obviously, there are 28, 29, 30 and 31 day months. If you are with a lender that utilizes what is known as an “exact day monthly interest factor” the monthly interest factor is not a constant value of 0.01 if the annual interest rate is12%. The monthly interest factor changes each month because of the exact number of days between payments. It should be obvious that by having combinations of the days per year and type of compounding, different lenders can use various monthly interest factors to their advantage. A lender who offers the same monthly payment for the same interest rate and same amortization period is no guarantee you have the same loan, and therefore the same interest costs. An amortization schedule is the ultimate proof because the interest factor is obvious if you analyze the very first line of the amortization schedule.