If you want to buy a house or condo but can’t afford to pay for it outright, then you’ll need the services of a bank or another type of mortgage lender to help you finance the property. The loan you are given is called a mortgage, but it’s not free money. You’ll need to make arrangements to pay it back and, along the way, you’ll inevitably be charged mortgage interest. What is mortgage interest and why is it important to understand for home buyers?
What is mortgage interest?
Every time you make a mortgage payment back to the bank (either monthly or bi-monthly), part of the mortgage principal (the original sum of money) is paid back and the remaining portion is the mortgage interest. In simple terms, the mortgage interest is the fee you pay for the privilege of using the bank’s money to buy the home. As such, mortgage interest is the gross profit a bank or mortgage lender makes when lending money to you.
How much mortgage interest you’ll pay over the lifetime of the loan, depends on the interest rate that you’ve agreed upon and the mortgage term. The ‘term’ is the number of years you committed to paying back the loan to this specific lender (also known as a mortgagee).
For example, you may have a $500,000 mortgage that is amortized over 25 years but with a term of five years. While your monthly mortgage payments are calculated on repaying the loan over 25 years, the term (five years in this case) is your commitment to making these payments to that specific lender for that specified period of time.
Reducing mortgage interest
Mortgage interest is the reason that homeowners strive to pay back their mortgages as quickly as they can. Why? Because mortgage interest can really add up.
One good strategy is to pay attention to the pre-payment options allowed by your lender. Pre-payment options are penalty-free opportunities to make extra payments against the principal debt owed. In other words, the bank or mortgage lender will charge you a penalty if you just decide to pay down your mortgage loan, unless that extra payment falls within their allowable pre-payment options.
Pre-payment options are a great way to significantly reduce the amount of overall interest you’ll pay to borrow money to buy your house. Why? Because consistently making extra payments against the money you owe reduces the overall amount of money owed, which reduces how much money is charged interest, which reduces the overall interest you pay.
Take, for example, a $500,000 mortgage on a 25-year amortization with a 4% rate on a 5-year term. The monthly mortgage payment on this loan is just over $2,630 and after a full 25 years of payments, the homeowner would’ve paid $289,030 in interest alone. But pay just $50 extra per week, and the homeowner would pay off their mortgage two years and 10 months early and save almost $37,000 in interest.
Is mortgage interest tax deductible in Canada?
No. Unlike in the U.S., mortgage interest is not tax deductible in Canada. However, there are certain situations when a person can use mortgage interest as a tax-deductible expense. For instance, a taxpayer may claim mortgage interest as a home office expense if they operate a home-based business. If you have maintenance costs that are related exclusively to your home office, you can deduct the entire portion of those expenses, as well. You can also declare a portion of your mortgage interest as an income tax deduction if you rent out a portion of your home or have an investment property and claim the payments as part of your income. If you’re not sure, always check with your accountant to see if you can write-off a portion of your mortgage interest.