What is a comparison rate?
When you’re loan shopping, you might be tempted to look for the product with the lowest advertised interest rate, but it’s important to remember there are usually other expenses associated with a loan. Fees out there include:
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Application fee
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Monthly fee
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Annual fee
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Redraw fee
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Offset fee
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Package fee
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Discharge fee
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Valuation costs
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Settlement costs
Your lender might not charge all of these, but a few. A comparison rate is a tool to help borrowers make more informed decisions by providing a single figure combining both the interest rate and the fees and charges.
Interest rate vs comparison rate
Looking at the comparison rate can be useful because it levels out the playing field. Some lenders like to offer seductively low interest rates only to sting you with a lot of expensive fees every year. In this case, picking one with a higher interest rate yet fewer fees could be more economical in the long run. Some lenders charge few, if any, fees. You can see a basic scenario below.
|
Home Loan A |
Home Loan B |
|
|---|---|---|
|
Advertised Rate p.a. |
5.30% |
5.50% |
|
Regular Monthly Repayment on $400,000, 25 year term |
$2408 |
$2456.35 |
|
Comparison Rate p.a. |
5.80% |
5.55% |
|
Fees payable p.a. (averaged out over 25 years) |
$2000 |
$200 |
|
Total cost on average per month |
$2574 |
$2473 |
Presumably you would lean towards the one with the lower rate. However, loan A has a large processing fee, as well as expensive annual fees, and when you include these costs, it means you’ll actually end up paying more per year.
Loan B on the other hand, has very few such costs. A 5 basis point difference on the comparison rate is $200, which might be for an annual fee. So even though it has a higher advertised rate, which is a turn off, it’s the fees that slightly win in the end.
Comparison rate lower than the advertised rate?
You might have seen a few home loans with comparison rates lower than the advertised rate. This is relatively uncommon as it’s usually the other way around. This is where it gets a bit funny, and doesn’t necessarily indicate there’s no fees to pay. It’s usually down to three main reasons:
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You’re on a fixed-rate home loan and your roll-off rate is lower than what you’re paying now.
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You have a home loan that has loyalty discounts.
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You’re on an interest-only construction loan while building your home that reverts to a lower P&I rate once construction is done.
How is the comparison rate calculated?
Section 71 of the National Consumer Credit Protection (NCCP) Act requires lenders to use a standardised formula to work out the comparison rate, and it’s not exactly straightforward. The comparison rate is calculated using the formula n x r x 100%, where n represents the number of repayments made per year (52.18 with weekly repayments and 26.09 for fortnightly) and r is the solution to, ahem, a much more complex formula as seen below:
where:
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j=the number of intervals between repayments.
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Aj=the outstanding loan amount at time j.
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Rj=the repayment to be made at time j.
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Cj=additional fees or charges that will apply when Rj repayment is due.
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t=the number of intervals between repayments that will elapse throughout the entire loan term.
While your eyes might have immediately glazed over at this formula, it’s probably enough to just know that by law, a comparison rate is required to be the total amount you will pay each year, in both interest and fees.
Despite the algebra above, it’s not an exact science. Repayments aren’t usually uniform over an entire loan term, for example, but it’s still a useful approximation. A more useful formula is probably: higher comparison rate = more $$$.
Limitations of comparison rates
If you’re choosing between loan products, comparison rates are usually a better way to work out which will be more expensive than just looking at the interest rate. However, there are several limitations of comparison rates that can mean you don’t end up paying exactly the amount the rate suggests.
Individual circumstances
Comparison rates are calculated based on a set of standard assumptions which may or may not reflect your situation. Credit history, the loan amount and the term length can all affect the costs and repayment terms for an individual.
Historically, banks have used a $150,000 loan size on a 25 year term as a yardstick to determine the comparison rate. However, that seems woefully out of date, because the average home loan size is well over $500,000 and most people take out a 30-year term, but pay it off in much less. Our comparison tables use $400,000 as a guide, as you will see in the disclaimer.
Variable fees
It’s possible to incur additional fees not included in the comparison rate calculation which would make the loan more expensive. Early termination fees are a good example, so if you’re interested in paying off your loan early, you’ll want to check these fees as well when comparing products, which won’t be included in the comparison rate.
Loan features
Many loans include features like offset accounts, redraw facilities or flexible repayment options, all of which can change how much you spend.
People chop and change lenders
How many people do you know who have stayed with a lender their entire 30-year loan term? Or taken the whole 30 years to pay it off? Many prioritise the home loan above all else, and work hard to pay it off much sooner. Further, many people refinance every few years to a better home loan deal.
So when you’re looking a lender, you’ll need to look at the specific fees payable. If you think you’ll refinance regularly, an annual fee might not be so important, but regular monthly fees could.
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