How Does Compound Interest Work on a Mortgage?

Home loans might seem complex and confusing – with such a significant financial commitment; you should try to understand the ins and outs of your mortgage. While there are home loan calculators to help you estimate the cost of your mortgage, you should know how your lender calculates your interest rate.

Whether you haven’t touched maths since high school or can’t wrap your head around compound interest, here is a quick refresher on calculating compound interest on your home loan.

How Does Compound Interest Work on a Mortgage

What Is Mortgage Compound Interest?

Compound interest is a type of interest added to your mortgage’s principal amount—or rather, it’s interest on interest. Compounding interest allows money to grow without limit. The accumulated interest is added back into the principal balance. The unpaid interest goes back into your principal when you reach the compound interest deadline.

Compared to simple interest, compound accrued interest might cost more overall. Instead of paying interest, you earn it. However, the same concept applies to compound interest on savings. If you deposit $100 in your savings accounts, it will add up to a substantial amount after a year or more.

Compound interest accrues according to its schedule. Each mortgage, credit product, or bank account will have an agreed or contracted compound frequency schedule. The more frequent the bank or lender compounds the interest, the greater the total amount owed. If you compound interest monthly, you will pay more than if you compound annually.

Therefore, interest rates only mean so much with compound rates—a 5% monthly compound interest rate is actually more expensive than a 10% yearly one.

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Example of Mortgage Compound Interest

Let’s say you have a mortgage of $100,000, earning interest at a rate of 5%. If the lender calculates the annual interest rate using a compound interest formula, you would have to pay $105,000 by the end of the year. After the second year, you would owe $110,250. If you had a simple interest mortgage, you would only need to pay $110,000 after two years.

While compound interest mortgages can charge you more over the home loan lifetime, compound interest may benefit you in other ways (e.g., in a savings account).

Simple Interest vs. Compound Interest

So, what is a simple interest rate? This type of interest only uses the initial mortgage balance. The amount owed on your mortgage won’t grow over time on previous interest paid. As a result, interest growth is slower. In contrast, compound interest grows faster.

As a borrower, it’s often in your best interests to pay simple interest on your loan. The existing interest charged isn’t included in future calculations. On the other hand, if you have savings in bank accounts, compound interest will help you increase your existing balance.

How Compound Interest Works

When you calculate the interest owed on your initial principal loan balance, you might not consider whether the annual interest rate is compounding or simple. Compounding interest adds interest paid back into your remaining loan balance; your mortgage repayments might struggle to make a dent in the total amount owed.

If you have a compounding mortgage, beware of the frequency. The compounding interest rate frequency determines how much interest accrues in a compound period. A monthly compounding interest, for instance, will add the outstanding balance back to your principal every month.

How Does Compound Interest Work on a Mortgage

How Compound Interest Grows

Because compound interest accumulates previously paid interest over time, it grows exponentially. Total interest payable does not divide equally between each year of the loan, as it does with simple interest.

Compound interest will grow significantly over the long term; home loans are long-term commitments, and a compound interest rate could result in a costly financial burden. Check out our example below to see how compound interest grows.

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               Year        Balance
How Does Compound Interest Work on a Mortgage

Compound Interest Schedules

As mentioned, the frequency of your compounding interest affects how much mortgage interest you pay overall. Mortgage lenders might calculate interest daily, weekly, monthly, or at an annual percentage rate. Compounded interest on home loans and other credit products is usually monthly. However, saving bank accounts are typically compounded daily.

Some banks and mortgage lenders also offer continuously compounding interest. This type of compound interest adds interest to the initial mortgage balance in every possible instance. This is excellent for savings accounts but disadvantageous for home loans and other credit products. It’s in the interests of the borrower that interest compounds less frequently.

How Do You Calculate Compound Interest?

Calculating compound interest is actually quite simple. Use the following formula to find out your compound interest mortgage repayments.

            B = P x (1 + R/N) ^ (N x T)

Each component of the formula stands for:

  • B: The total amount (both principal and compounded interest)
  • P: Initial principal value
  • R: Annual interest rate
  • N: Frequency of compounding period
  • T: Loan term

Compounding interest is more complex than simple; borrowers may find it confusing to calculate. It’s easier to use a loan amortisation calculator, which breaks down your initial principal amount and interest amount over the loan term. As your loan balance decreases, you’ll pay more towards the original principal balance and less interest.

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How to Calculate Your Home Loan Repayments

Follow our formula above if you have a compound interest mortgage and wish to calculate your monthly repayments. Let’s say you have a home loan principal (P) of $400,000. The annual interest rate (R) is 3%, the compounding frequency is monthly (N), and the life of the loan is 30 years (T).

So:   Total amount (B) = 400,000 x (1 + 0.03/12) ^ (12 x 30)

Therefore, the total mortgage payments equal $982,736.88. To work out how much you would pay each year or month, divide by the number of payments. So each monthly payment would be $6,824.56. Each annual principal and interest repayment would be $81,894.74.

On the other hand, with simple interest on the same mortgage, you would pay a total of $606,960 ($1,686 monthly payments). As you can see, compound interest results in more interest and significantly more money.

How Does Compound Interest Work on a Mortgage?

Factors Affecting Compound Interest

Several factors affect calculating compound interest.

  • Interest rate: A high-interest rate will mean you pay more on your mortgage over the loan term.
  • The initial amount of principal: The initial loan balance will affect the amount of interest you pay.
  • Compounding frequency: The more often your interest compounds, the more money you have to pay. The new interest amount adds to the existing principal and interest balance. The more times you calculate interest, the higher the final amount of interest you need to pay.
  • Loan term: As with any credit product, the longer your loans, the longer you earn interest.
  • Extra repayments: If you make extra repayments with your monthly payments or use an offset account or redraw facility, you’ll reduce the total interest payable as the balance is smaller.

When Compound Interest Can Help You

Compound interest isn’t always a bad thing. Of course, on a mortgage, it can cost you more money than other interest calculations. However, other instances when compound interest may benefit you include:

  • Savings: Compound interest means you earn interest on savings in your bank account than with simple calculations.
  • Investment accounts: The compound interest formula applies to some investment accounts.

When Compound Interest Is Negative

However, compound interest might mean you pay a lot more on your mortgage or other credit products and loans. Here are the disadvantages of compound interest.

  • Loans: All loan products, including mortgages, personal loans, student loans, and car loans, will result in more interest.
  • Credit cards: If you pay off your credit card balance every month, you won’t pay any interest. However, if you have a remaining balance, the interest might compound, resulting in higher interest repayments.

How to Make Compound Interest Work for You

Generally speaking, compound interest works in favour of the lender or creditor. If you’re investing money, you will benefit from compound interest. If you borrow money, the creditor will benefit. Follow these steps to get the most out of compound interest and minimise your losses.

  1. Make regular deposits and extra repayments to your mortgage. Keeping the balance as low as possible will ensure you don’t need to pay more mortgage interest than necessary.
  2. If you have a bank account with compound interest, deposit extra sums in there to maximise your interest savings.
  3. Try to pay your mortgage early. Of all your debts, mortgages last the longest and build up the most interest. Therefore, you’ll save vast sums if you pay your home loan early.
  4. Compare compound interest rates on your mortgage product options. Opt for the lowest interest rate with the least frequent compounding period.

Understanding Compound Interest

A mortgage with compound interest repayments isn’t the most cost-effective way to purchase a house. Unlike simple interest mortgages, compound interest costs far more throughout the loan’s lifetime. As an “interest on interest”, it may feel like you’re not impacting your mortgage repayments.

However, there are ways to make compound interest work for you. A savings account with compound interest, for example, is an excellent way to save money for a deposit on a house. Speak to one of our mortgage brokers today about your home loan options and whether you need to pay compound interest.

How Does Compound Interest Work on a Mortgage

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Frequently Asked Questions

Is a Mortgage Loan Compound Interest?

Generally speaking, most home loans do not use compound interest. However, that doesn’t mean that there are no mortgages with compound interest. If you have a compound interest mortgage, ensure that you do not miss any payments or pay late. Mortgages that compound interest daily – or monthly – might charge hefty penalties for late and missed payments.

How Is Compound Interest Calculated on a Mortgage?

Compound interest acts as interest on interest. Compound interest is calculated by multiplying one plus the initial loan amount by the annual interest rate to the compound periods minus one.

How Often Is Interest Compounded on a Mortgage?

If your mortgage has a compound interest rate, likely, it compounds monthly. Although some loans compound interest daily or weekly – it’s best to check the terms of your mortgage to find out how much you owe.

What Is an Example of a Compound Interest?

If you take out a mortgage with compound interest, you will pay interest on the unpaid interest sums. So, if your home loan compounds daily, then the bank or lender will calculate the interest each day.

Is My Mortgage Interest Rate Compound or Simple?

Contact your bank or lender to find out whether your mortgage interest rate is compound or simple. Most home loans use a simple interest rate, but it’s best to check to determine how much you owe.

Can Compound Interest Make You Rich?

If you have a compound interest savings account, your money will work harder for you than a simple interest account. However, compound interest on a mortgage or loan will cost more than a simple interest home loan.

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