First of all, what is a comparison rate and why does it matter?
if you search online, the definition mostly looks like this:”A comparison rate is a tool to help consumers identify the true cost of a loan. It factors in the interest rate, fees and charges and displays a single percentage rate that can be used to compare various loans from different lenders.” or “The comparison rate is designed as a tool to help you identify the true cost of a loan.”
And why does it matter? Because from 1 July 2003, the Australian Government made it mandatory to display a comparison rate for any advertisement of a credit rate – including home loans.
The definition of comparison rate states that it is a tool to help you identify the true cost of a loan, but does it really serve the purpose well?
Factors affecting Comparison Rates:
Comparison rates are calculated on a number of factors, including:
- loan amount
- term of the loan
- repayment frequency
- interest rate
- fees and charges (excluding government charges, such as stamp duty and mortgage registration fees)
How is the Comparison Rate Calculated?
The comparison rate is calculated based on the following numbers, no matter what your loan size is:
- $150,000 loan amount
- 25 year term
- principal and interest loan
SO WHAT’S WRONG WITH THE COMPARISON RATE?
4 Reasons the Comparison Rate may not help you choose the right loan:
- Comparison rates are specific to the product you choose, not the options you choose on a particular loan. For example, it won’t include some fees and charges which may or may not apply to you such as additional fees for an offset account, early repayment or redraw fees.
- It excludes the benefits of savings on other products like credit cards and insurance, often included in Professional Package loans. It also excludes any special deals that can be negotiated with the lender like fee waivers or discounts.
- It doesn’t consider the way features such as offset arrangements are structured.
- It is calculated for a standard $150 000 loan repaid over 25 years despite the fact that the average loan is much higher than this and most loans get repaid or refinanced within 5-7 years.
These end up over-emphasising the impact of fixed fees (which don’t vary with the size of the loan) like application fees which are usually a fixed dollar amount. It also minimises the impact of honeymoon rates, ongoing interest rate differences and fees payable on discharge.
As an example, (at the time of writing) Commonwealth Bank has a No Fee variable rate home loan at 4.77% with a Comparison Rate of 4.77%. Because there is no monthly fee payable on this loan, and the only payment you make is interest, the comparison rate will be the same as the advertised rate for all terms and sums borrowed. But beware; as I said earlier, not all fees are taken into account when calculating the comparison rate so you need to check your loan details before you believe anything you read.
If you see a loan with an advertised rate of 5.13% and an upfront fee of $1 000, it will have a Comparison Rate of 5.20%. But if you took up this offer and borrowed $450 000, your effective rate would be 5.15% over 25 years. So you can see how a comparison rate is really only accurate for loans of $150 000.
It can be even more misleading with fixed rate loans, because there is an assumption that these loans revert to the current standard variable rate at the end of the fixed period. This is unlikely to be the case in practice as most borrowers choose to refinance at the expiry of a fixed rate and many lenders will offer you a rate which is lower than their standard.
For example, HSBC has a 5 year fixed rate loan with a rate of 5.09% and a comparison rate of 5.65%. The main reason for the significant difference here is the HSBC standard variable rate is 6.1% driving up the average rate over the full 25 years.
These are just examples but the implication for you is that the Comparison Rate is not a particularly useful tool for comparing loans.