How banks calculate compound interest on loans

[cannon_fodder]

It strikes me as a bit odd, but if I input into any number of calculators on the web a bi-monthly payment loan (24 times/year) the calculators then compound by the same number of periods instead of monthly (I'm talking a loan which compounds monthly as opposed to semiannually which is normal for Canadian mortgages).

I would have expected that a calculator would compound monthly and if a person chose to have 24 or 26 payments / year, the effective interest rate would have remained equivalent to a monthly compounded rate. That does not seem to be the case.

As an example, a 6% loan rate compounded monthly is about 6.168% effectively with monthly payments. However, a 6% loan rate compounded monthly but with 24 payments per year is effectively 6.1757% based on the few calculators I sampled.

Do I have this wrong?

[Thalo]

Probably. Bi-weekly vs. monthly payments pay the loan down slightly faster, so I would assume a slightly lower effective rate.

[Icedawn]

Hm, I was reading something a few hours ago that might be relevant...

Hope this makes sense

"If payments are made more frequently than interest is calculated (i.e., if the chargee receives payments monthly when interest is calculated half-yearly), the determination of accrued interest in each payment may become complicated if the “deemed reinvestment principle” is either expressly applied by the parties or is deemed to apply. Basically, this principle provides that if the chargee has received any interest in advance of the time it is to be calculated, the chargee is deemed to have reinvested that interest and to have earned interest on it at the same rate as the interest rate set out in the charge. The actual interest paid by the chargor and the interest the chargee is deemed to have earned from reinvestment must total no more than the yield stated in the charge. Therefore, in this situation, an interest factor is applied and the effective interest payable under the charge is reduced accordingly. "

[happychef]

A 6% loan rate compounded monthly should have an annual rate of about 6.1677812 and the same loan with 24 payments should have a effective rate of about 5.9925186. Normally when converting a rate to another one with different payment frequency, always convert the first rate to the rate as if the loan is compounded once a year. And then convert taht rate to the other frenquency