Interest rate versus comparison rate

If you've ever shopped around for a home loan, you'll have noticed that two terms often pop up: interest rate and comparison rate. Understanding the difference between these two is important for anyone navigating the home loan market. So, let's break down these concepts.

What is the interest rate?

Simply put, the interest rate on a home loan, often referred to as the advertised rate or the headline rate, is the rate at which interest accrues on your loan balance annually. It not only affects your overall loan amount, but it also directly influences what your monthly repayments will be.

Lenders set their interest rates based on factors such as the Reserve Bank of Australia's decisions on the cash rate, competition in the marketplace, and their individual policies.

What is a comparison rate?

The comparison rate is a rate that reflects the true cost of a loan. It's more comprehensive than just the advertised interest rate, as it includes both the interest rate and most of the fees related to the loan, rolled into a single percentage figure.

The idea behind the comparison rate is to provide a figure that reflects the total annual cost of the loan, making it easier for borrowers to compare different loan products.

In Australia, it's mandatory for lenders to display the comparison rate alongside the advertised interest rate. This requirement was introduced to bring transparency to lending markets, ensuring borrowers were not being enticed by low interest rates that may be accompanied by high fees.

You will usually find the comparison rate beside the headline rate e.g. 5.85% p.a. variable rate (6.35% p.a. comparison rate*). Lenders must also provide a key fact sheet for the product they're offering which must also state the comparison rate and the typical fees applicable that influence the comparison rate.

What does the * stand for?

You will often see the comparison rate* with an asterisk next to it. This is generally to alert consumers as to how the comparison rate is calculated. It's based on a standard formula, typically assuming a $150,000 loan taken out over 25 years. (More on the maths below.)

While this provides a baseline for comparison, it's important to note that the actual comparison rate for your specific loan may be quite different, depending on your loan amount and term.

It's also important to understand the comparison rate does not include every possible cost. Costs like government fees, conveyancing fees, and certain conditional charges (such as early repayment fees) are not included.

See also: Home loan fees you should be aware of

Additionally, it might not account for the value of flexible loan features such as offset accounts or redraw facilities. This is because offset accounts might come with monthly or yearly fees, and/or there might be fees to access your redraw funds. This can impact the overall cost and benefits of the loan.

See also: Offset vs redraw - which is better?

If you've never closely considered comparison rates before, you can start by weighing them up against the competitive advertised interest rates in the home loan table below:

Important Information and Comparison Rate Warning

Interest rate vs comparison rate: What's the difference?

In simple terms, the advertised interest rate is the percentage the lender charges on the principal loan amount. It indicates how much you'll pay in interest but doesn't include any additional fees or charges associated with the loan.

On the other hand, the comparison rate provides a more comprehensive picture. It includes the interest rate you'll pay, plus most of the fees and charges related to the loan expressed as a percentage figure.

As such, the comparison rate offers a more accurate representation of the total cost over time. But it's not perfect.

How do lenders calculate the comparison rate?

The calculation of comparison rates is set by the Uniform Consumer Credit Code and involves a fairly detailed formula. Due to the complexity of the calculation, it's often recommended to use an online comparison rate calculator where you can simply plug the numbers in.

All comparison rates are calculated based on a standard loan amount and term. In Australia, that's a $150,000 loan taken out over a 25-year loan term. This standardisation aims to allow consumers to compare different loan products more easily.

However, most mortgages are considerably larger than $150,000 these days and many loan terms are generally 30 years, so it may not be entirely reflective of current market conditions.

Other factors that go into the calculation of the comparison rate include repayment frequency (generally monthly), the advertised interest rate on the product the lender is offering, and fees.

Fees that are typically used in the calculation of a comparison rate include:

• Application fee
• Preapproval fee
• Valuation fee
• Documentation preparation fee
• Legal fee
• Settlement fee
• Monthly account fee
• Annual package fee
• Periodical admin fee
• Discharge admin fee
• Documentation preparation fee
• Settlement fee
• Revert rate (on fixed-rate loans)

What isn't included in the comparison rate?

While the comparison rate provides a more comprehensive view of a loan's true cost than the advertised interest rate, it doesn't include every potential expense associated with a loan.

Key exclusions typically include:

• Stamp duty
• Conveyancing fees
• Fee waivers
• Break costs and early termination fees
• Deferred establishment fees
• Any optional costs such as early repayment and redraw fees
• Extra features like offset accounts or extra repayments

The devil is in the detail

A comparison rate is a handy indicator as to the true cost of the loan - but it doesn't tell the whole story. Nor should a relatively high comparison rate necessarily be a turn-off, but it should give a cause to pause and investigate further.

• If you're shopping around for home loans, it can be useful to also look at the key facts sheet (KFS) or a loan's fee schedule.

It's very rare that someone stays with the same loan and lender for their entire 25 or 30 year mortgage; interest rates also change, and borrowers often pay off their loan much sooner. Your personal circumstances can dictate the importance of certain fees.

• Refinancing: If you're changing lenders every year or two, you might not place as much importance on small regular fees versus one big establishment or discharge fee.

• Fixed-rate Loans: Fixed-rate loans often have a high comparison rate because it takes into account the revert rate once your fixed term ends. This is often very high and you can often arrange to switch to the lender's more competitive market rate, or refinance, once your fixed period ends.

• Regular vs Irregular Fees: Your personal taste for smaller regular fees versus one-off big fees can be different to someone else, which is why it's important to look at the KFS.

• Offset Accounts & Package Fees: Offset accounts might face a monthly or annual fee, which could still be worth it. Lenders also bundle extra features into their products, called packaged home loans, such as credit cards or discounted insurance or other products in turn for a neat yearly package fee.

All of these factors could influence the comparison rate, but you might find the trade-off worth it.

Why is the comparison rate important?

The comparison rate plays an important role in the process of finding a home loan. Simply put, it can offer a more realistic picture of a loan's true cost than its advertised interest rate. It includes additional fees and charges, providing a clearer understanding of the overall financial obligation of a loan.

It also helps simplify the task of comparing different loan products as it consolidates the overall cost into one figure, making it easier to weigh up options from various lenders even if they have different fee structures.

Keeping the market honest

The comparison rate aims to enhance transparency in the lending market, protecting borrowers from being lured by attractively low interest rates that may obfuscate high fees. By mandating that lenders display the comparison rate, it ensures consumers are better informed, helping them avoid loans that may seem attractive at first glance but are expensive due to hidden fees.

As you can see from the simplified table below, Home Loan B has a much lower advertised interest rate than Home Loan A. But when you take the various fees into account, Home Loan A works out to be a considerably cheaper product than Home Loan B.

	Interest rate	Comparison rate	Average Monthly Cost Over 25 Years with $600k Loan
Home Loan A	5.85%	6.35%	$3,811 vs $3,995
Home Loan B	5.20%	6.70%	$3,578 vs $4,126

Ideally, however, you'll want to keep fees to a minimum and a good way to assess this is if the comparison rate is close to the advertised rate.

What it means if the comparison rate is higher than the interest rate

It can be shocking when you think you've found an ultra-competitive home loan interest rate, only to notice the comparison rate is oodles above. This can mean a few things:

• Expensive or numerous fees
  A high comparison rate can be a warning that a lender charges significant upfront, ongoing, or exit fees. It's relatively common on packaged mortgage products, which may come with a lower interest rate and in-demand features, but tend to charge hefty monthly or annual fees.

• Honeymoon interest rate period
  Some mortgage lenders attract borrowers with a competitive, temporary interest rate discount, which may be applicable for the first year or two a person holds their mortgage. The comparison rate will reflect the fact that, once the honeymoon period is over, the repayments will jump.

• Fixed rate period
  Fixed home loans offer repayment certainty for a set amount of time, after which a home loan will likely be subject to a variable interest rate.

What it means if the comparison rate is lower than the interest rate

It's pretty uncommon for a home loan's comparison rate to be lower than its interest rate – but not unheard of.

This might happen if:

• A variable rate home loan includes built-in rate discounts
  As is the case with Unloan's lineup, which offers a 0.01% p.a. interest rate discount for each year a borrower holds their mortgage
  
  
• A home loan's rate is lowered when a borrower meets certain milestones
  As is offered by Athena's AcceleRATES feature, which automatically drops a borrower's variable rate when they surpass certain loan-to-value ratio (LVR) thresholds

However, if the numbers don't add up, it could be a mistake or a signal that a loan is structured in an unusual way. Always read the fine print!

Should I always choose the mortgage with the lowest comparison rate?

All this might leave you feeling like the lowest comparison rate is the best deal. But the lowest comparison rate (or interest rate, for that matter) doesn't always mean the best value for money.

There are other factors to consider when choosing a mortgage. Most notably, what you need from a home loan product.

The 'cheapest' mortgage might not offer features like an offset account - and if you have decent savings or you're an efficient saver, an offset account might save you more than a lower rate over time.

There might be other factors at play too. For instance, if you're a first home buyer with a deposit of less than 20%, it might make more sense to borrow with a lender that's part of the 5% Deposit Scheme. That way, you could avoid paying for Lenders Mortgage Insurance (LMI), potentially saving you more than a lower rate would have.

Bottom line: A low comparison rate is a great indicator, but don't ignore features that could save you more money in the long run.

_{Image by master1305 on Freepik}