Why Canadian Mortgages Compound Semi-Annually in Ontario

You may have noticed that the interest rate on your mortgage and the amount of interest you actually pay do not seem to line up neatly. One reason is compounding: how often interest is added to the balance for the purpose of calculating more interest. Many Canadian mortgage documents refer to interest being compounded twice a year, which surprises people who expect monthly compounding.

This article explains, in plain language, the federal Interest Act rules that sit behind these figures, how compounding affects cost, and what to look for in your own mortgage documents. It is general information about how things usually work in Ontario, not advice on your particular mortgage.

What compounding means in plain words

Compounding means that interest already added to your balance starts to earn interest itself. How often that happens is the compounding period. The more frequently interest is added, the more the balance can grow, all else being equal.

Compounding is separate from how often you make payments. A mortgage can compound at one interval and be paid at another. For example, a sample fixed-rate mortgage disclosure box published by the Financial Consumer Agency of Canada describes interest as compounded twice per year but charged monthly. That is why two mortgages with the same stated rate can cost slightly different amounts if their compounding or payment schedules differ.

What the Interest Act requires

The Interest Act is federal legislation that applies to mortgages on real property in Ontario. For a mortgage with blended payments or a similar plan, no interest can be charged on the principal unless the mortgage document states the principal amount and the rate, with interest calculated yearly or half-yearly, not in advance. That requirement is the statutory basis for the half-yearly (semi-annual) convention many borrowers see.

There is also a protection if the numbers do not match. If the rate stated under that disclosure is lower than the rate the other mortgage terms would produce, no greater rate than the stated rate can be charged or recovered on the principal advanced.

Some other Interest Act rules do not apply to mortgages. The rule that requires an express yearly equivalent when a rate is stated per day, week or month, otherwise limiting it to 5% per year, does not apply to mortgages on real property. The separate 5% per year rate applies only where interest is payable but no rate is fixed.

Terms you will see on your mortgage

Interest on missed payments and long-term mortgages

Borrowers sometimes hear about a higher penalty rate on late payments. The Interest Act limits this. No fine, penalty or rate of interest may be stipulated for or taken on arrears if it increases the charge on the arrears beyond the rate payable on principal not in arrears. A mortgage may validly provide for interest on arrears at a rate not greater than the ordinary rate.

That does not mean every extra charge is improper. The Ontario Court of Appeal has allowed late-payment charges that were substantiated and did not offend the Mortgages Act or the Interest Act. Whether a particular charge is allowed depends on the facts and what the lender can justify.

A separate rule applies to long mortgages. Where principal or interest is payable more than five years after the date of the mortgage, the borrower may, after five years, pay off the amount owing with three months' interest in lieu of notice, and no further interest is then chargeable. That is distinct from the prepayment terms in a typical one- to five-year closed mortgage.

What to do next

• Find the stated annual rate, the compounding period and the payment frequency in your mortgage commitment and charge terms.
• Check that the document states the principal amount and the rate, and how interest is calculated, if you have a blended-payment mortgage.
• Compare the rate in your documents with the rate your lender's statements appear to apply, and ask the lender to explain any difference.
• Review any charges on missed payments to see whether they increase the rate on arrears.
• Ask your lender for a written explanation of how your prepayment charge would be calculated before you plan to sell or refinance.
• If figures still do not add up, take your documents to a Ontario real estate lawyer to review.

Keep copies of every statement you receive. A short list of the dates and amounts that look wrong makes any conversation with the lender, or with a lawyer, much more productive.

Frequently asked questions