The math does not lie… mortgage interest rates vs. those of credit cards
The math does not lie… mortgage interest rates vs. those of credit cards
Isn’t it ironic that people complain about high mortgage rates, and stay relatively silent about credit card rates? While it may seem ironic, there are several reasons that can help explain this situation:
Visibility and understanding: Mortgage rates are typically more transparent and visible to borrowers. When individuals go through the process of obtaining a mortgage, they receive detailed information about the interest rate, associated fees, and the long-term impact on their finances. In contrast, credit card rates are often more obscure, with the focus being more on the convenience and benefits of credit card usage rather than the interest rates.
Long-term commitment vs. revolving debt: Mortgages are long-term commitments that borrowers enter into with a clear understanding of the loan's duration and interest rate. On the other hand, credit card debt is often revolving, with varying interest rates applied each month based on the outstanding balance. This dynamic nature of credit card debt can make it feel less predictable and may lead to less vocal complaints about interest rates.
Emotional attachment to homeownership: Owning a home is often seen as a significant milestone and a symbol of stability and success. Consequently, people tend to have stronger emotional attachments and financial investments tied to their homes. The impact of high mortgage rates on their ability to afford housing and potentially jeopardizing their homes can evoke more vocal complaints.
Media attention and public discourse: Mortgage rates tend to receive more media coverage due to their broader implications for the housing market, and the economy. This increased visibility can further amplify public discussions and complaints about mortgage rates compared to credit card rates.
In Canada, interest on credit cards is typically calculated using the “average daily balance method”. Here's how it works:
Daily Balance: At the end of each day, the credit card issuer calculates the outstanding balance for that day, including new purchases, cash advances, and any unpaid balance from previous days.
Average Daily Balance: The credit card issuer then adds up the daily balances for the billing cycle, and divides the total by the number of days in the cycle. This gives them the average daily balance.
Annual Interest Rate: The credit card issuer determines an annual interest rate, also known as the Annual Percentage Rate (APR). This rate is expressed as a percentage.
Daily Interest Rate: To calculate the daily interest rate, the APR is divided by 365 to get the daily interest rate.
Interest Calculation: The credit card issuer multiplies the average daily balance by the daily interest rate to calculate the interest charged for each day. This amount is added up for the entire billing cycle to determine the total interest charge.
In Canada, the compound interest method is the most common approach used by lenders. Here's how it works:
Principal Amount: The principal amount is the original amount of money borrowed for the mortgage, the loan amount.
Interest Rate: The mortgage agreement specifies the interest rate, which is expressed as an annual percentage.
Compounding Period: The compounding period determines how often the interest is compounded. Common compounding periods include monthly, semi-annually, or annually.
Monthly Payment: The monthly mortgage payment is usually divided into two parts: the principal payment, and the interest payment.
Interest Calculation: At the beginning of each compounding period (e.g., month), the outstanding principal balance is multiplied by the monthly interest rate. This calculates the interest charged for that period.
Principal Reduction: The portion of the monthly payment allocated to the principal reduces the outstanding balance.
New Balance: The interest charged is added to the outstanding balance, and the principal payment reduces the balance. The new balance becomes the starting point for the next compounding period.
This process is repeated for each compounding period until the mortgage is fully paid off.
Some numbers now
Using a loan amount of $50,000:
Loan amount and interest rate: Principal loan amount = $50,000, Interest rate = 5.04% per annum.
Loan term: 25 years, which is equivalent to 300 months (25 years * 12 months).
Monthly interest rate: Monthly interest rate = 5.04% / 12 = 0.42% per month (0.0504 / 12).
Amortization schedule: The bank creates an amortization schedule detailing the monthly payment, interest portion, principal portion, and remaining loan balance for each month.
Using these inputs, let's calculate the amortization schedule for the first few months:
Month 1:
Outstanding loan balance: $50,000
Monthly interest: $50,000 * 0.42% = $210
Principal repayment: Monthly payment - Monthly interest = $218.10 - $210 = $8.10
Remaining loan balance: Outstanding loan balance - Principal repayment = $50,000 - $8.10 = $49,991.90
Month 2:
Outstanding loan balance: $49,991.90
Monthly interest: $49,991.90 * 0.42% = $209.96
Principal repayment: Monthly payment - Monthly interest = $218.10 - $209.96 = $8.14
Remaining loan balance: Outstanding loan balance - Principal repayment = $49,991.90 - $8.14 = $49,983.76
The process continues for each subsequent month, recalculating the interest, principal repayment, and remaining loan balance.
Consider a credit card with an APR of 22%. You have a daily balance of $50,000 for the entire billing cycle of 30 days. Using the average daily balance method:
Total interest charges = ($50,000 * 22% * 30) / 365 = $1,143.84
Staggering difference…
Is a good idea to refinance your house to pay off credit debt knowing interest charges are significantly higher on a credit card than on a mortgage?
Refinancing your house to pay off credit card debt can be a viable strategy for some, but it's essential to carefully consider the pros and cons before making such a decision. Here are a few factors to keep in mind:
Lower interest rates: As mentioned, mortgage interest rates are typically lower than credit card interest rates. By refinancing your house and using the funds to pay off high-interest credit card debt, you may be able to reduce the overall interest you pay on your debt. This will save you money in the long run.
Consolidation and simplicity: Refinancing allows you to consolidate multiple debts into a single mortgage payment. This can simplify your financial situation and make it easier to manage your debt by having one monthly payment instead of multiple credit card payments.
This is one of many option… before proceeding with refinancing your home, call us, Fred and Martin – Mortgages, and we will do the math for you. We will help you assess the potential benefits, risks, and long-term implications of refinancing your home to pay off credit card debt.
Fred and Martin