Mortgage rates are usually quoted at the annual rate of interest set by the bank, but because of compounding interest, this will be slightly lower than the annual percentage rate, or APR, that you will actually pay. Compounded interest is interest paid on prior interest, which increases the overall cost of the loan.
The interest you pay each month can be calculated by dividing the mortgage rate by 12. For example, a 5 percent mortgage works out to 0.05/12, or just under 0.42 percent per month. However, the following month, you will pay the same 0.42 percent on both the mortgage principal and prior interest. For example, if you start with a mortgage of $100,000, you will incur $416.67 in interest the first month, but you will incur 0.42 percent of $100,416.67, or $418.40, the second month.
Compounded interest increases the overall cost of the mortgage. When determining how much you will pay in interest over the mortgage lifetime, use APR rates to calculate the total accurately.
APR can be determined mathematically from the posted rate of a monthly mortgage using the following formula: (1 + R/12)^12. The "^" symbol means "to the twelfth power," or multiplied by itself 12 times. For example, a 5 percent posted rate is (1 + 0.05/12)^12, or just under 5.12 percent APR.
Compounded interest is paid on the total outstanding balance of your mortgage. In the long run, this means that your initial payments against the mortgage are almost entirely against interest, rather than reducing the initial principal balance of the loan. Paying more than the amount due early on will greatly reduce your costs over the lifetime of the mortgage.
When calculating the total cost of your mortgage, be wary of any service fees that are tacked onto the principal, and that you do not need to pay immediately. These will also incur compounded interest over the lifetime of the mortgage and will cost you much more in the future. Principal that is not paid until the end of a 30-year period incurs 360 compounding periods, which means that $1,000 at the beginning of the mortgage will be (1 + 0.05/12)^360, or $4,467.74, at its end.