After MLN's last story about annual percentage rates (APRs), we got questions on how compounding and payment frequency affect APR calculations.
While many of you know this stuff, speaking with veteran brokers reveals that some are still unclear on the mechanics.
Ontario's mortgage broker regulator, the Financial Services Regulatory Authority of Ontario (FSRA), was kind enough to weigh in with definitive answers. We've included its responses below.
On compounding frequency
Question: When calculating APR, how does the compounding frequency (e.g., monthly versus semi-annual) affect APR?
Answer: Here's what FSRA said:
Compounding frequency has a significant effect on the cost of borrowing for consumers and should be included in the calculation of APR for disclosure, so that borrowers have all the information they need to make an informed decision.
The reason compounding frequency can have a noticeable effect on APR is because (assuming all other factors remain the same) the more often you compound, the more interest accrues.
For example, take a $500,000 mortgage with a 2-year term, amortized over 25 years and $5,000 in fees. If the interest rate of that mortgage is 6% compounding monthly, the total interest paid over the term is higher, making the APR 0.0736% higher than if the 6% was compounded semi-annually.
This is true for both amortizing and interest-only mortgages.
On payment frequency
Question: When calculating APR, how does the payment frequency (e.g., weekly versus monthly) affect APR?
Answer: FSRA provided the following guidance:
In most cases, payment frequency typically has a minimal effect on APR for amortizing mortgages. However, as part of their APR disclosure, brokers and agents should include the expected payment frequency at the time of their calculations.
For example, on that same loan shared in the previous question—a $500,000 mortgage at 6% compounded semi-annually with a 2-year term amortized over 25 years and $5,000 in fees—the APR with weekly payments is 0.018% lower than with monthly payments.
For interest-only mortgages, payment frequency has virtually no effect because the principal doesn’t decline and interest accrues at the same annual rate.
In terms of the regulatory requirement to adjust APR by payment frequency, some will file this under "You learn something every day."
Unfortunately, not all agents have clear instructions from their broker of record on the subject.
In practice, most—but not all—brokerages use software (e.g., their #POS# system) to calculate APRs, and they just trust it to be correct.
If there's any doubt, however, agents should chat with their compliance officer to confirm what's required in their jurisdiction.
