Effective vs Nominal Interest Rate in Canada | Explained

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In Canada, the fédéral Interest Act requires that mortgage rates be expressed using semi-annual compounding, which distinguishes the Canadian market from the United States where monthly compounding is standard. The nominal rate (also called the posted or advertised rate) is the one the lender communicates in their offer. The effective rate represents the true cost of borrowing by accounting for the frequency of interest compounding. In practice, a nominal rate of 5.00% compounded semi-annually corresponds to an effective annual rate of approximately 5.0625%. This difference may seem small, but on a $400,000 mortgage amortized over 25 years, it represents several thousand dollars in additional interest over the full loan term. For variable-rate mortgages, compounding is typically monthly, which produces a slightly different effective rate. AMF-certified mortgage brokers in Quebec must master these distinctions to properly compare offers from different lenders and clearly explain to their clients the true cost of their mortgage financing.

Effective vs Nominal Interest Rate: The Canadian Standard

When shopping for a mortgage in Canada, the rate displayed by the lender is the nominal rate. However, the true cost of your loan depends on how frequently interest is compounded — that is, added to the balance to itself generate interest. Understanding this distinction is essential for comparing offers from different lenders and evaluating the true cost of your mortgage.

Nominal rate

Effective rate

Semi-Annual Compounding: A Canadian Distinction

Canada's Interest Act stipulates that fixed-rate mortgage interest must be calculated using semi-annual compounding — twice per year. This legal requirement means interest is compounded at the midpoint and end of each year. In the United States, compounding is monthly, making American loans slightly more expensive at the same nominal rate. This Canadian standard therefore provides a structural advantage to borrowers in this country.

Difference Between Fixed and Variable Mortgages

Fixed-rate mortgage: semi-annual compounding (twice per year), as required by the Interest Act. A 5.00% nominal rate produces an effective rate of 5.0625%.
Variable-rate mortgage: monthly compounding (12 times per year), as the rate fluctuates with the prime rate. A 5.00% nominal rate produces an effective rate of 5.1162%.
Home equity line of credit (HELOC): monthly compounding. The effective rate is calculated the same way as for variable rates.

Concrete Impact on Your Mortgage

On a $400,000 mortgage at a 5.00% nominal rate amortized over 25 years, the difference between semi-annual and monthly compounding translates to approximately $3,000 to $5,000 in additional interest over the full loan term. This difference is automatically factored into your payment calculations by the lender, but it is important to understand when comparing fixed-rate and variable-rate offers. An AMF-certified mortgage broker in Quebec can help you make these comparisons transparently and choose the most advantageous product for your situation.

Frequently Asked Questions

What is the difference between nominal and effective interest rates?

The nominal rate is the rate advertised by the lender without accounting for compounding. The effective rate includes the effect of interest compounding and represents the true annual cost of borrowing. In Canada, semi-annual compounding means the effective rate is always slightly higher than the nominal rate for fixed-rate mortgages.

Why does Canada use semi-annual compounding?

Canada's fédéral Interest Act requires mortgage rates to be calculated with semi-annual compounding (twice per year). This standard protects borrowers by limiting how frequently interest is compounded, which reduces total cost compared to monthly compounding as used in the United States.

How do I convert a nominal rate to an effective rate?

For a nominal rate compounded semi-annually, the formula is: effective rate = (1 + nominal rate / 2)² − 1. For example, a 5.00% nominal rate gives: (1 + 0.025)² − 1 = 5.0625%. Online mortgage calculators perform this conversion automatically.

Is the effective rate the same for fixed and variable mortgages?

No. Fixed-rate mortgages in Canada use semi-annual compounding (twice per year), while variable-rate mortgages typically use monthly compounding (12 times per year). At the same nominal rate, the effective rate on a variable mortgage is slightly higher than on a fixed mortgage.

Does this difference have a significant impact on my payments?

On a $400,000 loan at 5% amortized over 25 years, the difference between nominal and effective rates represents approximately $3,000 to $5,000 in additional interest over the full term. The impact on monthly payments is modest, but the cumulative effect is significant over time.