What does a comparison rate tell you about a loan?

By Gerv Tacadena

A man stands in front of a giant percentage sign

Applying for a home loan is always going to involve a lot of numbers – at one point or another, you will have to use your math skills in order to understand what you are about to take on.

Loan products do not just come with interest rates; they also come with other costs from application fees to annual fees. In a previous article, we listed the kinds of fees that may come with your mortgage. One of the biggest concerns for any homebuyer is figuring out the total cost of the loan, and this is where comparison rates come in.

What is a comparison rate?
Comparison rates exist to give you an idea how much a loan would really cost by taking all the fees related to a loan and representing them with a single percentage. Using this figure, prospective borrowers can gauge the costs of their loan.

Banks and other lending institutions are required by law to indicate the comparison rate of the loan product they are advertising. This prevents lenders from using astonishingly low interest rates to attract borrowers and helps to inform them of the spot-on cost of the loan. This prevents lenders from using low interest rates to attract unwary borrowers who might eventually be paying more than they expected.

Typically, advertised comparison rates are worked out using a $150,000 home loan with a 25-year term.

In some instances, comparison rates are also called average annual percentage rate. Comparison rates also reflect how much loans with lower introductory rate would eventually cost.

What are the fees usually computed to get the comparison rate
Aside from interest rates, a comparison rate takes into account several fees including monthly and/or annual fee, establishment fee, valuation fee, settlement costs, and mortgage documentation fees.

However, comparison rates do not include government stamp duties, conveyancing fees, early termination and late payment costs, redraw fees, and deferred establishment fees.

How does a comparison rate tell you the total costs?
Let's say you are planning to borrow $200,000 with a 20-year repayment period for your home purchase. You are deciding which of the two home loan products to chose from:

  • Home Loan A has an interest rate of 5% and accumulated fees forming 0.5% of the total amount of the loan. In this case, the comparison rate is 5.5%.
  • Home Loan B has an interest rate of 4% but has fees and other costs accounting for 2% of the total borrowed amount. The comparison rate of this loan is 6%.

In this case, it would be more practical to go for the loan with the lower comparison rate, despite its higher interest rate. Over the lifetime of the home loan, you will be paying less overall than if you had taken the second offer.

It is important to remember that comparison rates do not apply to every loan equally. In the above examples, the comparison rates only apply for $200,000 home loan with 20-year repayment period. The percentage will significantly change with a different amount of repayment time.

If you are communicating with your lender, try to see how much of a change there would there be if the loan term is extended. While a longer term may decrease monthly repayments, it can also increase the overall cost of the loan owing to the interest. Some banks may offer discounted rates on large loan amounts and this could lower the comparison rate as well.

Lastly, payment frequency plays a huge role in the overall comparison rate. The more frequent your repayments are, the lower the rate will be.

Why are comparison rates important?
As mentioned earlier, comparison rates give you an idea how much it really costs to take on a particular loan. Therefore, a comparison rate is one thing to take into account as you examine which mortgage product is best for you. Do it right and you can save thousands of dollars after your repayment period.

The comparison rate will also help you understand which mortgage products have suitable interest rates and affordable cost structure for your situation.

Comparison rates are just one thing you should consider when it comes to a home loan, though – be sure to check out the features of the product to see if it will be suitable for your needs.

For instance, try to ask your lender if your mortgage product allows you to link an offset account, or if you can make extra repayments. Knowing if you can have a split loan facility is also a plus, as you can take advantage of the versatility of a variable rate while having a secure fixed rate for a portion of the loan.

If at the end of these comparisons you are still unsure, consulting with financial advisors and mortgage brokers can be a great help as you navigate through the ups and downs of the mortgage products you are planning to apply for. Aside from computing the comparison rates, these professionals will aid you in your quest in finding the right mortgage to help you secure your next property.


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