Interest rate vs comparison rate

By   |   Verified by Yvonne Taylor   |   Updated 26th July 2021

Interest Rate vs Comparison Rate
  • The difference between the interest rate and the comparison rate explained in plain English.
  • Why banks and building societies display comparison rates.
  • Find out the rate you will be paying.

Applying for a home loan and noticed there are two rates advertised? What is a comparison rate anyway? Read on to find out all about interest rates vs comparison rates and how they might affect you.

Definitions

Interest rate

The interest rate is the money your lender charges you for borrowing money.

A standard home loan consists of two parts – principal and interest, with the principal being the money you borrow to buy a home and the interest being the cost of borrowing it.

Interest is charged at an annual percentage rate on the principal over the life of the loan. The principal will reduce as you pay off your mortgage (unless you have an interest-only loan).

In practice, your lender will calculate the interest daily on your principal, dividing the annual rate by 365, but you will usually make repayments fortnightly or monthly.

For example, you might take out a loan of $300,000 at an interest rate of 3% over 30 years. Based on monthly repayments, you will pay $155,332 in interest over the life of the loan.

However, when financial institutions publish mortgage interest rates, it is the ‘bare’ figure and doesn’t include any additional fees which might apply to the loan, such as an application fee and monthly account-keeping fees. This bare interest rate is also sometimes referred to as the ‘advertised rate’.

Comparison rate

In contrast to the ‘bare’ figure of the advertised interest rate, the comparison rate includes most extra fees associated with the loan and is aimed at giving you a better idea of what you might pay over the course of the loan’s life.

However, it’s worth remembering the comparison rate is made according to a strict formula. That is, it assumes a $150,000 loan over 25 years. Given that the average home loan in Australia is now more than $500,000 and the average length of the loan is closer to 30 years, the comparison rate standard is somewhat out of kilter with real-life housing conditions in this country.

Why are there two rates anyway?

There are two rates, so you, the borrower, can try to form a more accurate picture of how much your loan will actually cost you, and which of two loans might work out to be cheaper. Lenders are required by law to provide a comparison rate alongside a loan’s advertised interest rate.

Unlike the straight interest rate, the comparison rate includes what you might have to pay in fees on top of your interest rate. These unavoidable fees will depend on the lender and the type of loan, but can include:

  • Loan application or establishment fee
  • Property valuation fee
  • Settlement fee
  • Monthly account fee

However, the comparison rate does not include government fees and charges such as stamp duty on the mortgage.

Nor does it include other costs such as break costs and early termination costs, or fees such as early repayment and redraw fees, since these are avoidable. Despite this, checking out the comparison rate can potentially allow you to save thousands of dollars in interest repayments.

For example, one home loan may have a higher interest rate than another, but a lower comparison rate because it has lower fees and charges and works out cheaper overall than a home loan that has a lower interest rate but higher fees and charges.

When were comparison rates introduced?

Comparison rates were introduced in 2003, which perhaps explains the assumed loan figure of $150,000 over 25 years.

Which products have both rates advertised?

Comparison rates are given for home loans, personal loans and car loans.

Each comparison makes different assumptions about the loan.

  • Home loans. As mentioned above, a home loan comparison rate assumes a $150,000 loan over 25 years.
  • Personal loans. A personal loan comparison rate usually assumes a $30,000 loan over 5 years, but if necessary check the individual lender’s assumptions.
  • Car loan. A car loan comparison rate also assumes a $30,000 loan over 5 years in most cases, but once again the calculation may vary depending on the lender.

What’s the difference?

Put simply, the interest rate is the rate you will be charged on the balance of your loan. This affects the size of your minimum monthly repayments.

The comparison rate takes into account fees and charges as well as the interest rate and represents the overall cost of the loan during the total repayment period.

What rate will you be paying?

Given that most loans come with fees and charges, it is likely you will be paying closer to the comparison rate than the interest rate. However, keep in mind comparison rates are made according to assumed loan conditions that may not apply to your situation.