They say comparison is the thief of joy, yet throughout life, we always seem to be comparing one thing to another. When it comes to comparison rates and mortgages, this is no exception. So in this instance, with a comparison rate, just what are we comparing to what?
The purpose of a comparison rate is to help you determine the true cost of a loan so you can then compare the actual benefits of loans offered by different banks and mortgage providers.
When you’re committing to a big loan, like a mortgage, you want to be set up for success from the get-go. There’s a lot of extra costs that you’ll be responsible for and it’s crucial to know what your true costs are going to be. This is where the comparison rate comes in.
So when looking to finance for our big purchase, lenders will often display two percentage figures next to each other in their marketing.
For most of us, our only understanding of these figures is that, at face value, we can see that the comparison rate is higher than the interest rate — and that’s pretty much where the understanding ends!
Where the difference lies is that the comparison rate compares loan fees and charges, terms, and repayment frequency, whereas the interest rate simply looks at the interest on the loan and nothing more. So let’s take a look at what’s involved with this ‘true cost’ by breaking it down into bite-sized pieces.
What Does ‘True Cost’ Really Mean In A Comparison Rate?
Though a comparison rate is broadly considered a reflection of the ‘true cost,’ there is of course fine print because #banking, am I right?! There are inclusions and exceptions, and understanding what these are will help you understand the ‘true’ true cost. Yes, you can roll your eyes now.
A comparison rate helps borrowers understand the real financial impact of a loan beyond just the interest rate, making it easier to compare different loans.
What’s included in a comparison rate?
- Application fees associated with the loan
- Settlement fees charged by the bank or lender
- Ongoing account keeping fees
- Discharge or exit fees
What’s not included in the comparison rate?
- Fees associated with optional home loan features (such as an offset or redraw facility)
- Government fees and charges (such as stamp duty, mortgage registration, and land tax)
- LMI (Lenders Mortgage Insurance)
- Late payment fees
It’s definitely worth noting that LMI is not included, as this is usually a considerable expense if you are seeking a loan with a lender when you have less than a 20% deposit. Good news though:
Comparison Rates As The Benchmark
A comparison rate sets a benchmark for evaluation. It gets the numbers in line and helps flesh out the details of a loan so you can see the differences from one loan to the next.
Comparison rates don’t look at different types of loans though, which means that fixed-rate and variable-rate loans are dumped into the same category, together with the loan size.
Now for the odd part: Comparison rates are calculated on a $150,000 loan over a 25 year term.
Huh?
Yes you heard correctly — the comparison rate you’re seeing is only for a $150,000 loan, not your specific loan size. This is to ensure that different lenders calculate using the same variables. However, this can cause some problems with the calculation of the comparison rate.
For example, comparison rates, when applied to fixed-rate loans, can be misleading, as it’s assumed that once the fixed period is over, the new rate applied to the loan automatically defaults to the lenders standard variable rate.
But here’s the catch: If you’re like most borrowers, once the fixed rate period is over, you will sensibly be looking to refinance. Refinancing saves you money because you can get the best available rate at the time — hopefully even lower than the regular one because the lender will oftentimes offer you a deal. But, well, they also might not.
Needless to say, comparison rates can’t make any predictions here.
All Of The Rates, Explained
When we set out to start dealing with lenders, we hear the word ‘rate’ all the time. If all this talk of rates is making your head spin and your eyes glaze over, here’s a breakdown of all the different types of commonly referred to ‘rate talk’ that is mortgage and loan adjacent.
Interest rate
An interest rate is the cost of borrowing money, or the reward for saving or investing money, expressed as a percentage of the principal amount over a specific period (usually one year). It represents the price you pay to a lender for the use of their funds, or the return you earn when you lend or invest your own money.
Interest rates are generally calculated with these three main factors:
- Principal amount: The original sum of money borrowed or invested.
- Interest rate percentage: The proportion of the principal charged as interest, typically on an annual basis.
- Time period: The duration over which the interest is calculated.
Fixed rate
A fixed rate is when a bank or lender agrees to uphold a given interest rate for the course of a loan term. At the time of signing, the duration of the loan term is also decided upon.
Fixed rates can sometimes disqualify any flexibility within the loan structure — for instance, a redraw facility on any surplus funds sitting within your primary loan account.
Variable rate
A variable rate (sometimes called an ‘adjustable’ or a ‘floating’ rate), on the other hand, shifts with the larger financial tides and is based on an underlying benchmark interest rate that changes periodically.
Any lender can increase or decrease the interest rate attached to a loan in response to decisions made by the Reserve Bank of Australia.
Cash rate
The cash rate is always a hot topic of conversation amongst the Wall Street types but may just continue to swirl in a sea of confusion for the rest of us, so let’s just nail it down.
The ‘cash rate’ is set by the Reserve Bank of Australia (RBA) and is the (near) risk-free benchmark rate (RFR) for the Australian dollar, meaning the cash rate is the interest rate on unsecured overnight loans between banks.
While that may sound a bit strange, rest assured that it’s merely just the interest rate for the money that the banks have to borrow in order to safely lend money to you.
As of February 2024, the RBA meets eight times per year to discuss and set this rate, rather than the historic schedule of meeting on the first Tuesday of each month. The Governor of the RBA then hands the outcome down to the public.
I think everyone would enjoy these moments more if we employed the services of a groundhog called Punxsutawney Phil. Failing that, the Governor might at least consider wearing a fancy top hat to soften the news (when bad), as interest rate rises and prolonged winters feel much the same.
Base rate
A base rate, in the context of finance and banking, is the same as the cash rate and refers to a benchmark interest rate that serves as a reference point for determining the interest rate on a variety of financial products.
Heart rate
Oops, that’s one rate too far. Though looking into financing your first home can definitely affect your heart rate!
How A Comparison Rate Works In Your Favour
So now that you understand what a comparison rate is and how it works, we can get into how to get comparison rates working for you.
Many homebuyers are surprised to hear that a lower interest rate doesn’t necessarily mean it’s the best loan option. Lower rate, bigger savings... right?
This is where the comparison rate really shines. It helps borrowers to compare loans with the same terms and amounts but at their true cost rather then before all the add-ons, offering a more holistic view than just the flat interest rate.
As mentioned earlier, there are other factors you should consider, such as features that are beneficial to your personal circumstances. These can have more weight in your decision-making. And of course, it’s still essential to check the fine print of each loan product before you make your final choice. Look at all the different variables and features on offer and see if there are distinctions between the comparison rates for each loan.
Hopefully, after you’ve done this, the comparison rate will simplify your decision-making by revealing this true cost and showing a total number that can be used to compare between two or more home loan packages.
As you probably understand, setting up a home loan is about finding the best rate for you. If you don’t do your research properly and use a comparison rate to your advantage, you could be losing money each year on your loan. A rookie mistake would be to rely completely on the comparison rate to do all the work for you — so don’t forget the other factors and the nuance of your own unique situation.