You’d think that a 6% interest rate means that you’d be charged $6 in interest on a $100 loan after one year, but this isn’t true. You’d actually be charged more. The difference has to do with compounding periods. It’s not hard to calculate the real interest rate being charged, but for some reason, banks aren’t required to tell the truth about interest rates.
For loans in the US and non-mortgage loans in Canada, interest is compounded monthly. For most mortgages in Canada, interest is compounded twice a year. I’ll explain Canadian mortgages first because they are a little easier to follow.
If you get a 6% mortgage in Canada, it is really 3% interest every 6 months. This means that without any payments, your outstanding debt is multiplied by 1.03 after 6 months. After a year, it has been multiplied by
1.03 x 1.03 = 1.0609.
This means that the real yearly interest rate being changed is 6.09%, not 6%. So, what? The difference looks small. Well, over the life of a 25-year $200,000 mortgage, you’d pay an extra $3100 in interest because of this small difference.
In the US, things are even worse. A published mortgage rate of 6% per year really means 0.5% per month. After a year, this compounds out to 6.17%. Over the life of a 25-year $200,000 mortgage, you’d pay an extra $5800 in interest because of this difference.
These examples are based on the current low interest rates. What if mortgage rates were at 12%? Over the life of a 25-year $200,000 mortgage, Canadians would pay an extra $14,000 and Americans an extra $27,000 because of the extra compounding.
Monthly compounding is used in both countries for most non-mortgage loans. If you maintain a $10,000 balance on a credit card for 25 years with 20% interest, you’ll pay an extra $4000 in interest because of the extra compounding.
Many department store credit cards claim that the interest rate is 28.8%, but this is really 2.4% per month which compounds to about 33% per year!
I assume that this form of legalized lying is permitted because of historical precedent. I’d like to see it stop, but I won’t hold my breath.