BEWARE OF THE COMPARISON RATE
What is a Comparison Rate and why does it matter? Whenever you see an interest rate quoted for a loan, it will be accompanied by a comparison rate; this is now a legal requirement for all lenders. The comparison rate is designed as a tool to help you identify the true cost of a loan.
It attempts to calculate the total cost of a loan and show this as an equivalent annual interest rate. It takes into account the amount and the timing of interest payments, fees and charges. This is supposed to make it easy for you to compare loans more easily.
Comparison rates can be useless and misleading for most borrowers.
While it is mandatory to include the comparison rate, the Government also requires that it comes with a warning. This should be a signal proceed with caution.
The warning states, This comparison rate is true only for the examples given and may not include all fees and charges. Different terms, fees or other loan amounts might result in a different comparison rate.
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 5.20% with a Comparison Rate of 5.20%. 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. Despite this, whenever you see a Comparison Rate that is significantly different to an advertised rate, see it as a red flag and look deeper.
Vince Scully | LifeSherpa
With over 25 years in Financial Services from consulting to management, Vince Scully is the go-to guy for wealth management and financial advice. Before creating LifeSherpa, Vince founded the Calliva Group; a fund manager, product issuer, adviser and lender. Vince is an adviser to the Wealth Management Industry, and prior to his role as CEO at Calliva, a senior member of Macquarie Bank’s infrastructure team.