Variable-Rate Interest-Rate Compounding: The Details

Here’s something most homeowners are surprised to learn: the interest rate you see advertised on a variable-rate mortgage might not actually be the real rate you pay.

Variable-rate mortgage interest is compounded one of two ways, either monthly or semi-annually, which changes your true cost of borrowing.

Why Compounding Matters

If you take out a $250,000 mortgage at a quoted 5% variable rate, two things will affect how much interest you actually pay:

1. Your payment frequency, and
2. How often the lender compounds your interest.

Many people assume that paying more frequently (bi-weekly vs. monthly) dramatically reduces interest. However, it doesn’t. Paying extra on your mortgage saves you money, not simply splitting the same payment into smaller chunks.

Where the real difference shows up is in the compounding method your mortgage lender uses.

Monthly vs. Semi-Annual: A Small But Real Difference

Here’s a simple example:

Two lenders both offer you a 5% variable-rate mortgage on $250,000.

• Lender A compounds semi-annually
• Lender B compounds monthly

Same advertised rate… but not the same cost.

Monthly compounding ends up costing you approximately 6 basis points more per year. It’s not a huge amount on its own, but over time, and especially when rates are higher, it can add up.

And if you can keep that money in your own pocket instead of sending it to a lender, why wouldn’t you?

Why We’re Only Talking About Variable Rate Compounding

Fixed-rate mortgages don’t have this issue. By law, fixed-rate lenders must quote rates using annual or semi-annual compounding, and nearly all choose semi-annual. So the compounding is consistent across the board.

Variable-rate mortgages, on the other hand, are where borrowers need to pay attention. Different lenders use different compounding rules, and the higher the interest environment, the more that di