Definition: The effective rate is the actual interest rate a borrower pays on a mortgage after accounting for compounding within the year. Unlike the nominal or posted interest rate, which doesn’t consider compounding, the effective rate reflects the true cost of borrowing.

Key points:

• Reflects compounding: The effective rate includes the effects of compounding periods (e.g., semi-annual compounding in Canada), providing a more accurate representation of the cost of a mortgage.
• Higher than nominal rate: Due to compounding, the effective rate is typically higher than the nominal or advertised rate on the mortgage.
• Calculation example: If a mortgage has a nominal rate of 5% with semi-annual compounding, the effective annual rate will be slightly higher than 5% due to the effect of interest being calculated and added twice a year.
• Useful for comparison: Effective rates are essential for comparing mortgage products that have different compounding periods, as they give a clearer view of the true cost of each loan.

Tip: When shopping for a mortgage, it’s helpful to ask lenders for the effective rate to get a precise comparison of borrowing costs across different mortgage products.

Last modified: November 5, 2024