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Comparison rate: What is it, and how is it calculated?
December 17, 2020● 4 minute read●
You might have come across the term comparison rate in the course of researching personal loans, especially house loans. Although less frequently discussed, the comparison rate on the home you’re eyeing can significantly contribute to the overall cost. So to avoid being blindsided by how exactly comparison rates affect your estimations, we’re giving you a brief overview of what a comparison rate is and how to calculate it.
What is the comparison rate?
A comparison rate is a type of interest rate that lenders, according to the law, have to display next to any advertised interest rate. It helps gives borrowers a better understanding of the actual cost of a property than the regular rate. To do so, lenders have to calculate their comparison rate using the interest rate, their application fee, other ongoing expenses (such as monthly accounting fees), and additional charges.
Another term you might know it by is the annual percentage rate (APR). It allows you to see how competitive a homeowner is at a glance and makes it easier for you to compare home loans side by side.
So if you were to see a loan with a low-interest rate but a higher comparison rate, then the lender probably has an additional fee that you need to consider before going ahead. Alternatively, it could mean that the loan reverts to a higher interest rate after a couple of years. So you have to be mindful.
Why is the comparison rate important?
You might know one or two stories, perhaps personally experienced a lender offering incredibly low rates on houses, only for it to be nothing but a scheme to attract borrowers. These lenders use misleading interest rates in their advertisements that lure unsuspecting customers into taking out loans with them. Little do they know that these shady lenders hike the property’s price and increase their services charges, so in the end, the deal isn’t as lucrative as you initially thought it was. If the borrower is lucky, they could save a little money. But more often than not, there’s no different than if you’d opted out of these ‘once-in-a-lifetime’ opportunities. In some instances, you might even end up paying a lot more than you anticipated, and that can put a lot of people in a tight spot.
So to limit such instances, Australia adopted the use of a comparison rate. Since it considers the interest rate, it is less likely to mislead people into signing agreements that aren’t beneficial.
How are comparison rates calculated?
As we mentioned earlier, comparison rates make it easier for you to compare different loans at a glance. Well, to do that, they have to maintain some form of unity. They typically use a sample loan amount and loan term of about $150,000 taken out over a twenty-five year period. So you must note this fact because if your loan is very different in terms of price and duration, the comparison rate won’t help you. But you can still use a home loan calculator to input the specific variables of the loan you’re considering and get a better estimation of the actual cost.
Let’s use a practical scenario to show you how the comparison rate works:
|Home Loan A|
|Home Loan B|
As you can see, at a mere glance, loan A looks like the cheaper option because the interest rate is lower in comparison to loan B. But because the comparison rate adds the fees, which ordinarily the lenders would not display, we can see that the second home loan is the cheaper selection. Of course, we’re assuming that both loans are working under the same terms of $150,000 over twenty-five years.
Now, let’s assume another scenario where you are taking out a loan with lender A, but with a $500,000. If the other conditions are the same, i.e. loan term is twenty-five year, the interest rate is still 4.5%, and charges are the same price; the actual comparison rate would come to about 4.5%. You’d also have the same result if the loan were shorter than 25 years. In such a case, the actual rate is higher than what is in the advertisement.
As a rule of thumb, you may want to note that when the loan term or loan size is lower than the sample, then the actual rate is higher than the displayed rate. But if the loan period or size is higher than the model, the actual comparison rate is usually lower. To avoid making a mistake, you can use a comparison rate calculator to find a home loan’s real value.
What doesn’t a comparison rate cover?
Lenders must reveal their comparison rates next to the interest rate to not mislead people. But sometimes they don’t include all the fees a lender might ask you to pay. Don’t worry, though; the annual percentage rate covers all the costs you must pay. So anything not included is optional, and you can choose not to pay it. That said, some of the fees that lenders don’t add in their calculation are:
- Redraw facilities
- Late payment fees
- Early exit fees
- Offset accounts
- Government charges
Government charges might be compulsory, but it’s lenders aren’t required to consider it. The other fees also affect the overall mortgage cost, but only in specific situations. The late payment fees, for example, aren’t a cause for worry if you budget correctly and make your payments on time. So always leave room for these extra fees when drawing out your payment plan for your loan.
So that’s all you need to know about comparison rates, how they differ from the interest rate, and how you can calculate it yourself. Now you can make more accurate estimations of the mortgage value of a house, and make more informed decisions before purchasing your next home.
Written by Jacaranda Team