Interest Only Loan Calculator
This calculator lets you calculate your periodic payments on a non-amortizing interest-only loan with a fixed interest rate. The payments calculated here are only interest payments. You need to add the payment of principal to the last payment calculated here. Also, you must add any fees you have accepted in your loan contract to these payments.
This calculator also allows you to calculate the payments on hybrid loans, consisting of an amortizing and interest-only portion.
We do have an educated guess about the direction of interest rates in the near future, but no one knows the exact value of the Bank of Canada policy rate or Canada Prime Rate in the future. As a result, no calculator can predict your interest on a variable-rate mortgage or loan.
Interest Only Loans
As the name suggests, an interest-only loan is a loan where the borrower only pays the interest during the loan term, and the loan does not amortize. If real property is used as collateral for the interest-only loan, it becomes an interest-only mortgage. Investors seeking leveraged investment in real estate often use interest-only mortgages for commercial properties.
Mortgage amortization is the process of paying off a mortgage loan over time in regularly scheduled payments. The most common mortgage amortization period in Canada is 25 years, but borrowers can choose amortization periods of as little as five or as long as 30 years. Each payment made during the amortization period consists of principal and interest.
The principal is the outstanding loan amount, and the interest is the charge for borrowing the money. As the borrower makes payments over time, the amount of the outstanding principal decreases. Consequently, the amount of the interest payment decreases as well. At the end of the amortization period, the mortgage is fully paid off.
Regarding residential homes, interest only mortgages are less common in Canada but more common south of the border. In the US, interest-only mortgages grew very fast in the years before the great recession. These differences in the prevalence of interest only mortgages are, to a large extent, due to tax law.
Investors can deduct all interest paid for purchasing a property from the income produced by that property for tax so that the effective interest rate would be lower for them. Also, in the US, taxpayers who elect to itemize their tax deductions can get tax relief for the interest they are paying on their primary residence mortgage. While Canadian homeowners would get no relief no matter how much interest they pay for their residence.
The Office of the Superintendent of Financial Institutions (OSFI) regulates Canadian banks and other Canadian financial institutions that the Federal Government regulates. OSFI has set out the framework for residential mortgages in Guideline B-20.
In Guideline B-20, interest only mortgages and all other non-amortizing mortgage products are grouped together as HELOCs. HELOC stands for home equity line of credit. The most common form of HELOC is a Line of Credit, with the main difference being that HELOC rates are much lower than unsecured lines of credit. A conventional mortgage is considered less risky than a HELOC because, in a conventional mortgage, as time passes, loan to value (LTV) decreases.
Moreover, in a conventional mortgage, the lender would learn about the borrower's financial distress more quickly than in a HELOC, where the borrower can use the HELOC itself to pay its installments.
As a result, OSFI limits non-amortizing mortgages (including interest-only mortgages) offered by federally regulated financial institutions (FRFI) to 65% of the home/property value. But this regulation permits a combination of HELOCs with conventional mortgages. As a result, an interest only mortgage from an FRFI cannot be for more than 65% of the home value. But it can be combined with an amortizing mortgage for a total of 80% of the home value.
Alternative lenders like credit unions and B-lenders do not have to follow OSFI’s directions.
Calculation of Loan Interest
Calculating the interest on a loan can be pretty simple if the compounding period and the payment period are the same. The interest rate quoted by your lender and written in your loan contract or mortgage contract is often an annual rate. This rate gives you a good approximation of the interest you will be paying. To know exactly how much interest you will pay, you need to know the compounding period of your loan. Compounding means adding interest to the principal. In other words, you need to know how often your lender would calculate interest on the interest you owe them.
In Canada, the law requires semiannual compounding for fixed-rate mortgages. As a result, semiannual compounding is very common. So the bank can add your interest to your principal and calculate the interest you owe for the payment you make in multiples of half a year after taking out your mortgage. While in other payment periods, they are not allowed to do so. This means you are paying the stated interest rate for each payment except the middle and last payment of the year, in which you would be charged a higher rate.
Instead of applying different rates in different periods, lenders often use a constant interest rate which is equivalent to the aforementioned two-rate scenario. To find this constant interest rate, we start by calculating the effective annual rate (EAR) corresponding to the semiannual compounding of the contractual rate.
Effective Annual Rate (EAR)
If we denote the yearly contractual interest rate by i, we would have EAR = (1+i/2)2-1 for semiannual compounding. In other words, you are calculating an annual interest rate equivalent to an interest rate of i/2 being charged each half-year. In general, if we have n compounding periods per year, EAR = (1+i/n)n-1 .
If you pay an installment every month, your interest is effectively compounded every month. Each period that you are making your payments is also the compounding period. Your periodic rate (PR), the interest rate which applies to your mortgage/loan with your compounding period, should result in the same EAR as your contract rate with your contract compounding. In other words, EAR+1 = (1+PR/12)12 for monthly payments. Thus, for monthly payments, we have PR = ((1+EAR)(1/12)-1). In general, if there are m payments per year, PR = ((1+EAR)(1/m)-1).
Numeric Example:
Mr. and Mrs. Alpha are offered an interest-only loan of $210,000 with an interest rate of 4.09%, compounding semi-annually. To calculate the monthly interest, they need to pay, one starts by calculating the effective annual interest rate (EAR). The interest rate of 4.09% with semiannual compounding means paying 2.045% every half year. Thus EAR = (1.02045)2-1 = 0.0413182025. Mr. and Mrs. Alpha will be paying interest every month. So we need to figure out a rate of interest, i, that when compounded monthly, would result in the same EAR of 4.132%. That is (1+i)12 = 1.0413182025. I = 1.0413182025(1/12)-1 = 0.003379649. This is the monthly rate (PR) that they have to pay. Given their principal amount of $210,000, they must make monthly interest payments of $210,000*0.003379649 = $709.73.