Nominal vs. Effective Interest Rate: What’s the Difference?

It’s important to know what type of interest you’re paying when you take out a mortgage.  There are basically two types, but each of them is sometimes known by more than one name.

  • Nominal Interest Rate. Also known as simple interest rate. Nominal interest is calculated on the original      principal only. If you borrow $100,000 for one year at 7%, you end up paying back $107,000.
  • Effective Interest Rate. Also known as compound interest. With effective interest, the interest rate is applied to the original principal AND all the accumulated interest. If you borrow $100,000 for one year at 7% and the interest is compounded semi-annually, you end up paying back $107,122.50. Therefore, the effective interest rate is actually 7.1225%. In Canada, this is known as the Annual Percentage Rate (APR) and it’s the rate that Canadian mortgage lenders are required to quote.

Of course, actual mortgages are more complicated than this because payments are made monthly (or even more frequently), rather than at the end of the year. But the result is still the same: the effective interest rate is slightly higher than the nominal interest rate. If you find mortgage rate calculations confusing—and who doesn’t!—feel free to give me a call. I’d be happy to sit down with you, explain what you should be looking for and make sure you get the lowest rate available!

Kupina Mortgage Team

Leave a Reply