Given the intricacies and possibilities around home loans, the so-called comparison rate may not always be helpful. As a tool, it can be too blunt for the job.
We trust ourselves all the time with the comparisons we make in everyday life between items as varied as shoes, cars and even people.
So, we’d expect that a comparison rate would be a handy tool to help make better estimates of differences and similarities of goods and services. The more complex the service, the more valuable we’d hope the comparison would be.
But given the intricacies and possibilities around home loans, the comparison rate may not always be helpful.
What exactly is a comparison rate?
The government’s MoneySmart website defines it as follows: “A rate that helps you work out the true cost of a loan. It includes the interest rate and most fees and charges relating to a loan, reduced to a single percentage figure.”
Hence whenever you see an interest rate quoted for a loan, it will be accompanied by a comparison rate. It’s now a legal requirement for all lenders to help identify the true cost of a loan.
This is done by showing the equivalent annual interest rate, which considers the amount and the timing of interest payments, fees and charges. It’s supposed to make it easier to compare loans, but such rates can be useless at best and, at worst, misleading for some borrowers.
Comparison rates come with an asterisk which signals the following warning: “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 is wrong with the comparison rate?
To help explain, here are four reasons to be wary.
1. Comparison rates are specific to the product you choose, not the options you decide on a particular loan. For example, it won’t include some fees and charges which may or may not apply to you. Examples are additional fees for an offset account, early repayment or redraw fees.
2. It excludes the benefits of savings on other products like credit cards and insurance, often included in wealth/professional package loans. It also excludes any special deals that can be negotiated with the lender, like fee waivers or discounts.
3. It doesn’t consider the way features such as offset arrangements are structured.
4. It’s calculated for a standard $150 000 loan repaid over 25 years, although the average loan is much higher than this. Plus most loans get repaid or refinanced within 5-7 years.
It doesn’t correctly model the impact of fees
The comparison rate can end up over-emphasising the impact of fixed fees. They don’t vary with the loan size like application fees, which are usually a fixed dollar amount.
It also minimises the effect of honeymoon rates, ongoing interest rate differences and fees payable on discharge.
For example, the CBA’s advertised standard variable rate home loan at the time of writing (20 July 2021) boasts a featured rate of 3.85% with a ‘wealth package’, but the comparison rate is 4.27%. As stated earlier, not all fees are considered 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 2.64% and an upfront fee of $1 000, it will have a comparison rate of 2.70%. But if you took up this offer and borrowed $450 000, your effective rate would be 2.66% over 25 years. So, you can see how a comparison rate is only accurate for loans of $150 000.
It’s even less reliable on fixed-rate loans
It can be even more misleading with fixed-rate loans. There’s 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. Most borrowers will refinance when their fixed rate expires and many lenders offer a lower rate at this time.
These are just examples, but a good reminder that the comparison rate is not particularly useful when 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.
This article contains general information only. It should not be relied on as finance or tax advice. You should obtain specific, independent professional advice from a registered tax agent or financial adviser in relation to your particular circumstances and issues.