Interest rates are simply the borrowing costs applied to the principal amount of a loan. If a consumer deposits money into a financial institution then they are the lender and will earn interest income. Alternatively if the consumer borrows money from a financial institution then they will pay interest as their cost of borrowing.

Interest rates are described as a percentage rate. The interest rate 3.5% would be expressed as 3.5/100. When calculating the interest payable, one simply multiplies the interest rate by the principal balance by the period of the loan. So if you borrowed $100,000 for 1 year at a rate of 3.5% then you would pay $350.00 in interest ($100,000 X 3.5% X 1Yr).

Over the period of the contract interest may begin to compound onto itself, that is, interest may be calculated on previous interest accumulated. Although interest rates are typically described over a 1 year period the compounding frequency may be more frequent. For example, you may have a loan that charges 3.5% annual interest with monthly compounding. An interest rate that compounds more than once per year provides for a higher annual percentage rate (APR) then the same interest rate with annual compounding.

In Canada, fixed rate mortgages must be disclosed with semi-annual compounding. This government disclosure requirement ensures that consumers can compare apples to apples when shopping for their mortgage. This law does not exist however for variable rate mortgages, and as a result some variable rate mortgages and most home equity lines of credit compound monthly. When you are signing the acceptance for your mortgage you will be presented with a cost of borrowing disclosure which will outline the annual percentage rate or APR. The APR converts the disclosed interest rate to an annually compounding rate and also includes any fees that are required to finalize the mortgage.