Understanding Comparison Rates: What They Include and Exclude
When you’re in the market for a home loan, car loan, or personal loan, you’ll often encounter two different rates: the interest rate and the comparison rate. While the interest rate is crucial, the comparison rate provides a more comprehensive view of the loan’s true cost. This article will explain what comparison rates are, how they are calculated, and what they include and exclude, helping you make more informed financial decisions.
What is a Comparison Rate?
A comparison rate is a tool designed to give borrowers a clearer picture of the true cost of a loan. It combines the interest rate with most of the fees and charges associated with the loan, presenting this total cost as a single percentage. This makes it easier to compare different loan products from various lenders.
Why is the Comparison Rate Important?
The comparison rate is important because it helps you understand the overall cost of a loan, not just the interest rate. A loan with a low interest rate but high fees might end up costing more than a loan with a higher interest rate but lower fees. The comparison rate helps you see through these differences and choose the loan that is truly more cost-effective.
How is a Comparison Rate Calculated?
The comparison rate is calculated using a standard formula that takes into account several factors, including:
- Interest Rate: The base rate charged on the loan amount.
- Upfront Fees: These can include application fees, property valuation fees, and legal fees.
- Ongoing Fees: Monthly or annual service fees that are charged throughout the loan term.
- Discharge Fees: Fees that are payable when the loan is paid off, including settlement and document preparation fees.
For example, if you take out a $150,000 loan over 25 years with an interest rate of 5%, but there are additional fees that add up to 0.5%, the comparison rate might be 5.5%. This rate gives you a more accurate picture of what you will be paying over the life of the loan.
What Does the Comparison Rate Include?
The comparison rate includes most of the costs associated with a loan, such as:
- Interest Rate: The nominal interest rate applied to the loan.
- Application Fees: Fees charged when you apply for the loan.
- Valuation Fees: Costs for property valuation.
- Loan Establishment Fees: Costs for setting up the loan.
- Legal Fees: Charges for legal services related to the loan.
- Settlement Fees: Costs associated with finalising the loan.
- Monthly Account Keeping Fees: Ongoing fees charged monthly.
- Admin Fees: Additional administrative costs.
- Discharge Fees: Fees for closing the loan account at the end of the term.
What Does the Comparison Rate Exclude?
While the comparison rate is a valuable tool, it does not include every possible cost. Some of the exclusions are:
- Government Fees: Such as stamp duty, mortgage registration, and land tax.
- Optional Fees: Fees for optional features like offset accounts or redraw facilities.
- Late Payment Fees: Penalties for missing repayments.
- Variable Costs: Costs that can change over time, such as interest rate changes after a fixed period.
- Lenders Mortgage Insurance (LMI): Insurance required if your deposit is less than 20% of the property value.
Practical Examples
Let’s look at two hypothetical loan offers to understand how comparison rates work:
- Loan A: Has an interest rate of 4.5% with $1,000 in upfront fees and $10 monthly fees. The comparison rate for this loan might be 4.8%.
- Loan B: Has an interest rate of 4.7% with no upfront fees and $5 monthly fees. The comparison rate for this loan might be 4.75%.
Even though Loan A has a lower interest rate, the comparison rate reveals that Loan B is actually cheaper when all costs are considered.
Tips for Using Comparison Rates
- Always Compare Like for Like: Ensure you are comparing loans with the same amount, term, and repayment frequency.
- Look Beyond the Comparison Rate: While useful, the comparison rate should not be the only factor in your decision. Consider other loan features and your personal financial situation.
- Ask for a Breakdown: If a comparison rate seems unusually high, ask the lender for a breakdown of the fees and charges included.
- Consider Your Loan Term: The comparison rate is usually calculated based on a standard loan term (e.g., 25 years). If your loan term is different, the comparison rate might not be as accurate.
Understanding comparison rates is crucial for making informed decisions when shopping for a loan. By considering both the interest rate and the comparison rate, you can get a clearer picture of the true cost of a loan and avoid any hidden fees that might catch you off guard. Always remember to compare loans based on the same criteria and consider all aspects of the loan, not just the rates. With this knowledge, you can confidently navigate the loan market and find the best deal for your needs.
By understanding what comparison rates include and exclude, you can make more informed financial decisions and choose a loan that best suits your circumstances. Always consult with a financial advisor or mortgage broker to navigate the complexities of comparison rates and loan terms effectively.