What Is A Comparison Rate and How Much Is The Fine Print Costing You?
With interest rates hovering around all-time lows, more and more property investors and homeowners are considering refinancing for a better interest rate and a better deal. And many lenders are happy to oblige by serving up the so-called, “lowest interest rates around!”
Of course, the low-interest rate environment does present great deals, but a low level of financial literacy—evidenced by a CUA National Mortgage Survey—may prevent many Australians from taking full advantage of these deals.
The survey focused on Australians’ understanding of comparison rates—a popular measure among lenders used to quote the cost of a loan. Among the survey’s findings:
- Only 29 percent of Australians understand what a home loan comparison rate is.
- 43 percent of survey respondents misunderstood what the comparison rate is.
- 28 percent of respondents admitted they had no idea what the comparison rate was.
With so much demand, competition is heated and these quick quotes help lenders attract potential customers. The problem lies less in comparison rates themselves, and more in how they’re being advertised by lenders and understood by consumers.
Read on to find out what a comparison rate is, how comparison rates are calculated, and how a misunderstanding of these rates is costing Australians thousands of dollars.
What is a Comparison Rate?
Comparison rates were introduced by the Australian government to protect consumers against misleading rate quotes.
The Australian Securities and Investment Commission defines the comparison rate as follows: A comparison rate is a rate that helps you work out the true cost of a loan. It reduces to a single percentage figure the interest rate plus most fees and charges relating to a loan. The comparison rate allows you to compare loans from different lenders to find out how much it will cost you.
The fees and charges not included in the comparison rate calculation include:
- Redraw fees
- Early termination fees
- Fees for switching lenders
All these fees are called ‘event-based,’ meaning they may or may not happen. On the day the comparison rate is calculated, you won’t know if you plan on redrawing your loan or terminating it early. So it’s important to consider whether you need the flexibility to redraw or terminate your loan without paying a huge fee.
The comparison rate calculation also does not include cost-saving features such as fee waivers and interest offset agreements. Adding in potential fee waivers and interest offset agreements can completely change the cost of a loan.
I believe comparison rates DO help consumers understand the full cost of a loan–including the fees – when they take the time to compare interest rates. They’re a good, quick measure, and a low comparison rate is never a bad sign, but they don’t tell the whole story.
That’s why, we always encourage our clients — especially property investors — to look beyond the “lowest rate.” We’ve had numerous cases where a deal didn’t look as competitive at first glance, but ended up saving clients hundreds and thousands of dollars. But how? And what does that have to do with comparison rates?
To begin that discussion, I’d like to go back and review the numbers behind a comparison rate.
How Comparison Rates are Calculated
The formula for a comparison rate looks like this:
Comparison Rate = ((Loan Amount * Interest Rate) + Fees) ÷ Loan Amount
It’s important to note, however, how comparison rates are advertised. The official government definition of the comparison rate is based on a loan amount of $150,000 with a term of 25 years. Most comparison rate schedules that you’ll get from lenders use these numbers to calculate the comparison rate.
I’ll dive into exactly how large of an effect different loan amounts may have on the comparison rate. (Hint: it’s more than you expect.)
Are Comparison Rates Good or Bad?
Before we go into the nuances of comparison rates, you should remember that the comparison rate is a very useful measure. A good mortgage broker will start by taking the time to compare many loans and their respective comparison rates before he/she makes any recommendations. And of course, a good mortgage broker always keep his/her clients’ individual circumstances in mind, because a great product for one client may not be the best product for another.
Compare Interest Rates and Comparison Rate Schedules—Reading the Fine Print
As I mentioned, comparison rates might trip up a potential investor or home buyer because of how they are advertised, not because they’re a bad measure.
But how are comparison rates advertised? Generally, lenders will provide their prospective customers with a comparison rate schedule. This schedule lays out various loan products with their interest rates alongside the comparison rate. At the bottom of this rate schedule, you’ll find some fine print that most people skip over. You may also see something similar if you’re shopping online.
The fine print will look something like this:
You may notice the part about fees that aren’t included. Later, I’ll cover how the fees and cost savings that aren’t calculated in comparison rates may affect your loan. For now, I want to focus on the second sentence (in bold), and the statement followed by the asterisks (underlined). Specifically, I’ll show you why these calculations don’t always give you a clear picture of the cost of your loan.
First, let’s look at the underlined, which says that the comparison rate is based on a loan of $150,000 over 25 years. For the time being, focus on the loan amount ($150,000) that the comparison rate is being calculated on.
In July of 2017, the Australian Bureau of Statistics reported that the average loan size for owner-occupied housing was $380,000. With an average home loan amount of $380,000 (double the amount used in the comparison rate calculation), you can start to see how some people get tripped up on comparison rates.
Now, most of my investor clients look for loans in the amount of $850,000 and above. That’s more than 5 times the amount you’ll see on a standard comparison rate schedule. If your loan is a 25-year, $1.1 million loan at a 4% interest rate, the comparison rate on that is 4.03%. The comparison rate schedule won’t show that rate. Instead, you’d see a 4.26% comparison rate, leading you to believe the loan is a far worse deal than it really is.
This leads us back to our main point: comparison rates, taken without consideration of your personal circumstances, don’t give a full picture of a loan’s cost.
If you take into consideration the loan amount that you’re looking for, the comparison rate changes significantly. Keep reading to find out how this difference leads some people to believe that their loan is tens of thousands of dollars more expensive than it actually is.
The following chart shows how the difference between comparison rate and interest rate changes as the loan amount gets larger. These rates were calculated based on an annual fee of $395 and a twenty-five- year loan term.
But why does this matter?
Consider that you’re in the market for a home loan of $850,000. You go online and start to compare interest rates on various loans. You find a loan with an interest rate of 4%, but the comparison rate is 4.23%. You’re immediately turned off by the high comparison rate, and move on to find a better deal.
The comparison rate was 4.23% based on a $150,000 loan, but that rate would go down to 4.041% if you did the calculation with an $850,000 loan. That might not seem like much, but it works out to a difference of $136 per month.
Over the life of a twenty-five-year loan, a $136 per month difference comes out to a total difference of $40,800. This is a huge difference that you won’t notice if you’re just glancing at the comparison rate and not reading the fine print.
You should also note that interest rates are inversely related to loan terms. In other words, the longer the loan term is, say 30 years instead of 25, the lower the interest rate. And vice versa for shorter loan terms.
But differing loan amounts and terms are not the only things you want to consider when comparing interest rates and their comparison rates. In this next section, I’ll dig even deeper into the features of a loan that comparison rates leave out, both good and bad.
Comparison Rates—Digging Deeper
When a homeowner calls and asks about the comparison rate on a loan, I like to review exactly what a comparison rate is with them. As mentioned earlier, comparison rates were introduced to give consumers a better idea of the real cost of a loan, but they don’t tell the whole story.
As mentioned previously, the comparison rate calculation does not include some of the fees and cost-saving features such as fee waivers and interest offset agreements.
Interest offset agreements can greatly reduce the amount of interest you pay, and that’s something that won’t show up in a comparison rate. Have a look at the following charts and notice how the “home loan balance” decreases with an interest offset account.
Keep in mind that the home loan balance is what you pay interest on. Because an interest offset account reduces your loan balance, you pay less interest just for holding your savings in the offset account.
Home Loan with an Interest Offset Account
Home Loan Without an Interest Offset Account
Comparison Rates—One Important Thing To Take Away
If you take away one thing from this post, it should be that finding the best deal on a mortgage, be it a home loan or an investment loan, is about far more than a single number.
As I mentioned before, a low comparison rate is never a bad thing. I just want to emphasise that comparison rates—and interest rates for that matter—are not the only thing to consider.
By now, you should have an idea how to identify a reliable mortgage broker, i.e look for the one who starts with your needs, and then the loan (not the other way around).