How Mortgage Interest is Calculated

Mortgage interest is the cost of borrowing money for a mortgage.

Your lender will charge you an interest rate that appropriately reflects the risk they undertake by extending financing to you.

How Do Lenders Determine Mortgage Rates?

There’s a wide range of factors that lenders consider when they assign your mortgage rate, including:

Mortgage Type: Lenders will set different rates based on key aspects of your mortgage.

These include the rate type (fixed vs variable), your term length, amortization period, down payment size, and whether prepayments are allowed.

Credit History: Lenders will evaluate your credit report to gauge your ability to handle mortgage payments.

If your credit history is riddled with late payments for example, you may not get the best rate the lender is offering.

Income and Employment Status: Lenders prefer to issue mortgages to borrowers who earn a steady and reliable income to meet payment obligations.

Debt Service Ratios: Lenders will examine your current debt obligations to gauge whether they’ll hamper your ability to make regular mortgage payments.

Eligibility for a Discount: Depending on your negotiation skills, you may be able to persuade your lender to offer you a rate considerably lower than their initial offer, a large probability of this happening depends on all of the aspects noted above.


From an economic perspective, the prime rate influences variable mortgage rates, while fixed mortgage rates are based on government bond yields.

How Lenders Quote Mortgage Rates

Posted Rate: The posted interest rate refers to the rate lenders advertise to the public on their websites.

Prime Rate: The prime rate is the basis of the interest rate charged on variable rate mortgages.

Typically, they’ll express a variable mortgage rate as prime +/- a certain percentage.

Contract Rate: Most borrowers take the opportunity to negotiate a lower mortgage rate than the posted rate.

The contract rate (or discounted rate) is the real interest rate agreed upon with your lender and the one you end up paying on your mortgage.

How the Type of Mortgage You Choose Affects Your Interest Rate

The key characteristics of your mortgage can significantly impact the interest rate you qualify for, so it’s worth exploring them in detail.

Fixed Rate vs Variable Rate

Fixed rates are inherently riskier for lenders than variable rates, so you can usually expect higher rates if you opt for the former.

Open vs Closed

In general, open mortgages, which afford you the privilege of making additional payments toward your outstanding balance without any penalties, come with higher rates than closed mortgages.

Conventional vs Non-conventional

A conventional mortgage is one where you contribute a down payment of 20% or more.

As a result, you’re absolved from buying mortgage insurance, which acts to protect the lender should you default on your loan.

Lenders generally charge lower rates on non-conventional mortgages, since they are required to have mortgage default insurance, largely derisking the loan for the lender.

Term Length

The longer your mortgage term length you choose, the higher the interest rate you can expect to receive.

Amortization Period

Your amortization refers to the length of time needed to pay off your mortgage in full through regular payments.

The longer the amortization schedule, the more time there’s for interest to accumulate, so you’ll incur more interest charges over time.

Couple sitting with mortgage broker discussing how mortgage interest works

How Does Mortgage Interest Work in Practice?

Once your lender finalizes your mortgage, interest will accrue on your balance immediately.

You’ll be responsible for paying interest with each mortgage payment you make.

Depending on your mortgage type, your interest rate will remain the same throughout your entire mortgage term (fixed) or change periodically (variable).

Once your current term ends, you can renew your mortgage contract for a new one.

At this point, you’ll have the opportunity to negotiate a new interest rate with your lender.

In Canada, the interest on your mortgage is subject to compounding.

By law, rates on fixed mortgages compound semi-annually.

As a result, your contracted interest rate will always be slightly higher than the one you negotiated with your lender once the effects of compound interest are incorporated.

For variable rate mortgages, the compounding frequency varies from lender to lender.

Components of a Mortgage Payment

Four components comprise your mortgage payment: principal, interest, property taxes, and mortgage insurance.


The principal refers to the total amount of money you borrowed and must repay to your lender.

A portion of each mortgage payment you make is allocated to the principal, gradually decreasing over time.


Interest is the cost of borrowing money on a mortgage.

It’s what your lender charges you as compensation for the risk they assume by loaning money to you.

Your interest costs will be highest during the first few years of your mortgage’s lifespan and gradually decline as you pay down the loan.

Property Taxes

Typically, you’d pay your property taxes to your local government as a lump sum, independently of your mortgage payment.

However, you can also merge your property tax bill into your mortgage payments to pay it gradually rather than in one large sum.

Mortgage Insurance

If your down payment is less than 20% of your home’s value, your mortgage is classified as non-conventional.

The purchase of mortgage insurance on behalf of your lender is mandatory with this type of mortgage.

Most homeowners opt to roll the mortgage insurance premium into their principal and pay it over time through their regular payments.

How Mortgage Interest Works for Different Types of Mortgages

Fixed Rate Mortgage

With a fixed rate mortgage, your interest rate will never change for the duration of your mortgage term.

As an example, suppose you acquire a mortgage with the following characteristics:

  • $500,000 principal
  • 25-year amortization period
  • 5% interest rate
  • Monthly payment frequency

Here’s how your payment schedule would look for the first three months:

Month Beginning Balance Payment Interest portion Principal Portion
1 $500,000 $2,908.02 $2,061.96 $846.06
2 $499,153.93 $2,908.02 $2,058.47 $849.55
3 $498,304.38 $2,908.02 $2,054.97 $853.05

Over time, the amount of your payment allocated to interest will decrease, while the portion to principal will increase.

Variable Rate Mortgage

Your interest rate may fluctuate during your mortgage term on a variable rate mortgage.

Your variable rate moves up or down in tandem with your lender’s prime rate; thus, any change in the prime rate will affect your total interest expense.

Your monthly payment will always remain fixed, regardless of how much your mortgage rate shifts.

However, what does change is the percentage of each payment that your lender dedicates to the interest.

Continuing with our previous example, suppose you choose a variable rate mortgage.

Your lender assigns you a 4.75% interest rate instead of 5%.

Here’s how your payment schedule would look initially:

Month Beginning Balance Payment Interest portion Principal Portion % Of payment allocated to interest
1 $500,000 $2,837.28 $1,959.86 $877.42 69.08%
2 $499,122.58 $2,837.28 $1,956.42 $880.86 68.95%
3 $498,241.73 $2,837.28 $1,952.97 $884.31 68.83%
4 $497,357.42 $2,837.28 $1,949.50 $887.78 68.71%

Now, let’s assume that after six months, the prime rate rises, which triggers an automatic increase in your variable rate from 4.75% to 5%.

Here’s how your payment schedule would look over the next four months:

Month Beginning Balance Payment Interest Portion Principal Portion % Of payment allocated to interest
7 $493,683.64 $2,837.28 $2,035.91 $801.37 71.76%
8 $492,882.27 $2,837.28 $2,032.34 $804.94 71.63%
9 $492,077.33 $2,837.28 $2,028.76 $808.52 71.50%
10 $491,268.81 $2,837.28 $2,025.16 $812.12 71.38%

As you can see, with a 0.25% rate hike, your monthly payment stays the same, but a larger percent of your payment is now allocated to interest.

It’s important to understand the impact of interest rates on payment amounts and the portion going to principal vs the portion going to interest.

While not too long ago we were in a low interest environment, here’s an example of the above variable rate mortgage with a 1.75% interest rate.

Notice that the percentage of payment allocated to interest is almost half.

Month Beginning Balance Payment Interest portion Principal Portion % Of payment allocated to interest
1 $500,000 $2,057.43 $726.52 $1,330.91 35.31%
2 $498,669.09 $2,057.43 $724.59 $1,332.84 35.22%
3 $497,336.25 $2,057.43 $722.65 $1,334.78 35.12%
4 $496,001.48 $2,057.43 $720.71 $1,336.72 35.03%

Key Insight

According to a report from Mortgage Professionals Canada, 77% of all mortgages are fixed rate, 18% are variable, and 5% are a combination of both.

Adjustable Rate Mortgage

An adjustable rate mortgage works much like a variable rate mortgage – your contracted interest rate will vary based on changes in your lender’s prime rate.

However, there’s one crucial difference: each rate change will alter the size of your regular payments.

We’ll use our previous example to illustrate the difference.

Your initial payment schedule will be identical to a variable rate mortgage: $2,837.28 paid monthly, with roughly 69% of the payment applied to interest.

However, with a 0.25% rate adjustment after six months, your payments will approximately increase as illustrated below:

Month Beginning Balance Payment Interest Portion Principal Portion % Of payment allocated to interest
7 $493,683.64 $2,901.85 $2,035.91 $865.94 70.16%
8 $492,817.70 $2,901.85 $2,032.34 $869.51 70.04%
9 $491,948.19 $2,901.85 $2,028.76 $873.09 69.91%
10 $491,075.10 $2,901.85 $2,025.16 $876.69 69.79%

Under an adjustable rate mortgage, your monthly payment increases by $64.57 ($2,901.85 – $2,837.28).

Frequently Asked Questions

  • How long do you pay interest on a mortgage?
  • Is mortgage interest compounded monthly?
Mark Gregorski

Mark is passionate about educating people on how the financial markets work and providing tips to help them better manage their money. Mark holds a bachelor’s degree in finance from the Northern Alberta Institute of Technology and has more than a decade of experience as an accountant.

Outside of writing and finance, he enjoys playing poker, going to the gym, composing music, and learning about digital marketing.