Compounding Interest Mortgage Rates

The first thing a mortgage borrower needs to understand when they are borrowing for a home is how the interest rates being quoted are calculated. For example, if a lender quotes you an interest rate of 3% on a $100,000 loan (about prime), it is intuitive to think that we will be paying a net amount of $3000 every year in interest.

However, that’s now how this works. In fact, the borrower will be paying a total amount of $3045.33 in interest. That’s a full 1.2% higher than we initially estimated! How can this be happening?

Banks calculate interest charges on a basis that compounds daily. This means that the bank re-applies the 3% interest rate every day of the year, based on how much of the loan is outstanding, so that it can perfectly account for how much is outstanding on a daily basis.

This also means that the bank makes more money, because they are running their interest equation every day, as opposed to only once per year.

While this does make the most sense for everyone involved, it is misleading that the bank should quote you only 3% upfront, when they are really charging 4.2%. However, this works both ways. If you pay down your principle by an extra amount in a given month, the dollar amount of interest that you will be charged the next month will be much less (maybe $2,800), because you owe the bank less overall.

Keep that in mind, because I’ll be explaining how to use that to your advantage later on when we start dealing with Home Equity Lines of Credit.

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