Have you ever looked at an advertised loan rate and gotten really excited about the low interest rate? But then noticed another rate called the ‘comparison rate’ which appears quite higher? Does this confuse you about the cost of loan? A comparison rate should make things easier rather than more difficult but that isn’t always the case. There is also more than meets the eye as well.
Basically the job of a comparison rate is to help consumers compare apples with apples. The idea is that a potential borrower can directly compare different lending products. The comparison rate reflects the ‘real interest rate’ you are effectively paying once all the fees, expenses and charges are also taken into account. It is these extra costs of a loan that can change the real interest rate you end up paying.
For example, let’s assume you are comparing two loans.
- Loan #1 has the cheaper advertised interest rate but it also charges a $299 annual fee
- Both charge a $300 settlement fee
- No other fees attached
The comparison rate highlights this difference in fees. You will notice that despite having a higher advertised rate, Loan #2 has the lower comparison rate. Loan #1 effectively sees you pay a higher interest rate because of the $299 annual fee spread over 25 years.
|Advertised Rate||Comparison Rate|
This is a good thing. It prevents lenders from drawing in borrowers on the promise of a low rate, but then actually having them pay back more than expected (due to fees and other costs in the fine print). Would-be borrowers can directly compare different home loan interest rates. The only problem with the comparison rate is that they must be calculated over a 25 year term and on an amount of $150,000 according to legislation.
“So what?” you may be thinking. It doesn’t appear to be a big deal but it can make a significant difference. Let’s take a quick look.
As indicated, it is always 25 years and $150,000 that is used to determine the comparison rate. But what happens if you want to borrow a different amount? Do the above comparison rates still remain relevant? As a comparison rate they do, but as an indication of the true cost of the mortgage to you they begin to lose relevance.
Let’s look at Loan #1 from above. Below we have charted the real interest rate for different loan sizes from $200,000 to $800,000 (but still using a 25 year term).
It quickly becomes apparent that as the loan size increases, the interest rate you are effectively paying gets closer and closer to the advertised rate. In this example, if you were actually looking to borrow $450,000 (highlighted in RED), then the effective rate you are paying is more like 3.945% rather than the comparison rate of 4.153%. The comparison rate didn’t provide you with a good indication of what real rate you would be paying.
Does this then mean that the comparison rate is useless to you as a consumer? The answer is no.
Let’s return to Loan #2 from above. Despite having a higher advertised interest rate it had a better comparison rate. What does the chart look like for various loan sizes under Loan #2?
The chart above illustrates how the comparison rate can be used to give a broad overview of which loan is effectively cheaper. Note how Loan #2 has a much flatter curve? This is due to the lack of extra fees – the advertised and comparison rates will always be quite similar.
Also note the cheaper real rate all the way up to around $450,000 when compared to Loan #1? So the lower comparison rate of Loan #2 from the table above (3.952%) was a good indicator that Loan #2 was the cheaper loan if looking to borrow up to around $450,000.
Now here is the caveat. Once you go past $450,000 Loan #1 actually begins to become cheaper despite having the higher comparison rate. It makes sense when you think about it. As you borrow more and more the interest rate becomes more important in determining how much in total you pay back over the years. Loan #1 wins because it continues to converge towards a lower advertised rate of 3.84% than Loan #2 and its advertised rate of 3.94%. As the loan size becomes larger, the effect of the $299 annual fee becomes less signficant on the overall cost.
But just when you thought you had it I will introduce one more variable into the equation – loan discounts. These figures are based on real products we have available at the time of writing. If you were actually looking to borrow over $500,000 the lender providing Loans #1 and #2 would give a further discount and we would then be talking about 3.74% vs 3.84% as the advertised rates (and 4.055% and 3.852% as the comparison rates). So it is also important to be aware of what is available to you when looking at comparison rates as other factors may come into play.
So what have we learned?
- Comparison rates are a good way to quickly compare which loans may be cheaper
- However, loan size can have an impact on which way to go
- It is also very important to be aware of loan size discounts that may require another level of analysis to determine the correct choice
This post only focused on rates. This isn’t the only factor to be concerned with when comparing loan products. It would be silly to go with a cheaper rate if it didn’t offer features that are necessary to achieve your financial goals. For example, if buying a home that you want to turn into an investment property eventually, an offset account attached to the loan is a basic necessity. Saving some dollars on a lower interest rate in this case would end up costing you more in the long term as you would lose the ability to maximise your tax benefits down the track. It’s not just enough to compare interest rates.
Below is a simple comparison rate calculator. It will not only display what your comparison rate, but also the actual effective interest rate you pay based on the actual loan size, loan term and any costs including application fees or an upfront fee such as ours (add it to the application fee – the difference is usually only around 0.02%).