It’s important to understand both terms when comparing loans so you can make a well-informed decision. Below, we break down the difference between an interest rate and comparison rate and how it’s calculated.
What is an interest rate?
In a nutshell, an interest rate is the amount charged to a customer by a lender for borrowing money. It is usually charged as a percentage of the principal loan amount. By charging interest, lenders are able to not only make a profit but have an incentive to lend you money and take on the risk by doing so.
The interest rate charged per year by your lender is determined by a number of factors including, but not limited to:
- Your credit score (generally, the higher the score, the lower the rate);
- The type of interest rate (fixed vs. variable);
- Length of repayment term;
- The Reserve Bank of Australia’s (RBA) official cash rate;
- Market competition.
There are two types of interest rates: fixed interest rates and variable interest rates. A fixed interest rate is where the rate remains the same throughout the life of your loan. This can be helpful for those who want to know exactly how much they’re paying and budget accordingly. On the other hand, a variable interest rate sees the rate go up or down depending on the RBA’s official cash rate and market conditions. A variable interest rate can provide more flexibility for the borrower. It also generally comes with the option to make extra repayments without being charged a penalty fee.
What is a comparison rate?
Simply put, a comparison rate allows you to understand the true cost of taking out a loan. It is expressed as a percentage and includes the loan’s interest rate as well as the fees and charges associated with the loan. It is a legal requirement in Australia for lenders to display the comparison rate alongside the advertised interest rate.
A comparison rate can make it easier to compare loans and services offered by lenders and help you choose the right one for your financial situation. Plus, it could potentially save you hundreds of dollars in fees.
How is a comparison rate calculated?
A comparison rate, also known as the Average Annual Percentage Rate (AAPR), is calculated using a formula set out and regulated by the Uniform Consumer Credit Code (UCCC). This formula must be used by all financial institutions and mortgage providers in Australia. The calculation itself can be quite confusing so we recommend finding a comparison rate calculator online.
Alongside the interest rate, a comparison rate generally takes into account the:
- Amount borrowed;
- Loan term;
- Fees and charges (e.g. establishment fees) associated with the loan;
- Frequency of repayments.
Keep in mind that a comparison rate is a guide and doesn’t include all fees and charges. For example, a comparison rate doesn’t include:
- Optional fees (e.g. early repayment fees, redraw fees);
- Cost savings (e.g. fee waivers, redraw facility, offset accounts);
- Government fees and charges (e.g. stamp duty, mortgage registration).
Where can you find the comparison rate?
As mentioned before, lenders are legally required to display the comparison rate alongside the interest rate on all loans including personal loans, car loans, and home loans. This was made mandatory in 2003 after amendments to the Consumer Credit Code were applied. It was introduced to stop lenders from advertising low rates while hiding hefty fees and charges. It also serves to help consumers easily compare loans.
Alongside displaying a comparison rate, lenders are also required to provide a warning about the accuracy of the rate as well as a key facts sheet. This sheet includes information about the loan product such as the interest rate, comparison rate, and the total amount to be paid back over the loan term.