When it comes to judging home loans, there is an easy way to instantly see how much they cost without reading all the fine print – by using comparison rates.
Comparison rates are different from interest rates. While interest rates tell you how much your lender charges you on the balance of your loan, the comparison rate provides you with a single percentage figure that combines the interest rate and all the other upfront and ongoing fees and charges related to the loan. In essence, comparison rates help you determine the "true cost" of a loan at a glance.
Your lenders are mandated by law to advertise the comparison rate of their mortgage product to help you compare it with other offerings in the market. This prevents them from misleading potential borrowers into taking a supposedly low-cost and low-interest loan with unexpected high fees and charges.
How do you check comparison rates?
When comparing two or more home loans with similar advertised interest rates, comparison rates will reveal how much they really cost over time.
Here’s how it works: For instance, Home Loan A has an advertised rate of 5.25% while Home Loan B has 5.75%. Looking at the advertised rate of the two loans, it would seem practical to choose A over B. However, it is important to factor in that these advertised rates are only introductory ones that will only last for 12 months of the loan. Let's say A has a standard variable rate of 6.5% and B has 6.25%.
Taking into consideration the current variable rates of the two loans as well as all the other charges and fees, A has a comparison rate of 6.75% while B only has 6.35%. In this case, A’s 5.25% advertised rate turns out to be more expensive than it appears.
There are also instances when comparison rates are lower than the given interest rates. This only happens when the fixed interest rate is higher than the variable rate of the loan.
Most banks typically advertise the comparison rate of a home loan offering based on an example loan amount of $150,000 with a term of 25 years.
How are comparison rates computed?
Comparison rates are also called the average annual percentage rates (AAPR), which under the law, should include the following items:
1. Interest rate
The biggest chunk of the comparison rate comes from the actual interest rate charged by your lender for your home loan. The interest rate is a major part in calculating the comparison rate of your home loan.
2. Fees and other costs
Some lenders charge monthly account fees for mortgage accounts, while others have annual package fees. There are also other charges such as establishment fees, settlement fees, valuation fees, and mortgage documentation costs. All of these charges —upfront or recurring — affect the overall cost of the loan and should be accounted for when computing for comparison rates.
3. Loan period
How long you intend your mortgage to be set for also influences the overall cost of your loan. The longer your loan term is, the higher the overall cost will be. While a longer term lowers your monthly repayments, it also creates a way for banks to earn more interest from your loan.
4. Loan amount
This is already a given. However, there are instances when comparison rates are lower for larger loan amounts due to discounted interest rates and other features given by the lender.
5. Repayment Frequency
The frequency of repayments is also an important factor in determining the comparison rate of a loan. Frequent repayments will help you reduce your outstanding balance regularly, lowering the overall comparison rate.
It is important to take note that some factors are not included in the computation of the comparison rate, including stamp duties, conveyancing fees, late payment fees, break costs for fixed-rate loans, deferred establishment fees, and redraw fees.
Why is it important to compare loans?
Comparison rates give you the opportunity to analyse each mortgage product and determine which suits your needs and financial capacity.
You have to see to it that you compare home loans accurately by looking at offerings that are of the same type. You do not want to compare a fixed-rate loan with a variable-rate loan, as they will have different interest rates. It is also suggested that you weigh the comparison rates of home-loan products with similar features.
Your goal is to get the best deal. After all, a home purchase is one of, if not the, biggest transactions you will ever make, so it pays to do some research.
An ideal deal will also give you the best value for money. What might seem like a quite small difference in comparison rates could help you save thousands on your home loan.