What is a comparison rate and how is it calculated?

When shopping for a home loan, you’ve probably noticed something called a comparison rate sitting beside the interest rate. But what is the difference between the two? Why is the comparison rate important?

Let's get into what borrowers and home buyers need to know.

The comparison rate gives you the ‘true’ cost of a loan by combining the interest rate and any additional fees or charges into a single percentage rate. This makes it easier to compare loans from different lenders.

All mortgage lenders are required by law to display the comparison rate wherever a headline rate is mentioned. This prevents them from advertising a loan as cheaper than it really is. 

While the comparison rate will contain all the main costs, it’s not all-encompassing. Other factors that might result in cost-savings — such as fee waivers, cashback deals, and the ability to make extra repayments — aren’t typically factored in.

When calculating the comparison rate, a lender will take into account the interest rate along with any unavoidable fees or charges associated with the loan. These fees can usually be broken down into three categories:

Upfront fees:

• Application fees
• Property valuation fees
• Pre-approval fees
• Legal fees
• Document preparation fees
• Settlement fees

Ongoing fees:

• Monthly or annual service fees
• Package fees

Discharge fees:

• Discharge admin fees
• Document preparation fees
• Settlement fees

There are a number of home loan costs (and potential savings) you might encounter that aren’t included in the comparison rate but will still need to be factored into your budget. These include:

• Government charges, such as stamp duty and mortgage registration fees.
• Fees for services that you may or may not use, such as redraw or early repayment fees.
• Lenders mortgage insurance (LMI).
• Late payment fees.
• Fee waivers.
• Cashback deals.
• Fixed rate break costs.

Add-ons like an offset account, redraw facility, and the ability to make extra repayments, which can make a big difference to the overall cost of your loan, won’t show up in the comparison rate. This is because how you use these can’t be accurately accounted for.

The comparison rate you see advertised is just an indication of how much a loan will cost. Importantly, lenders will make a few assumptions when calculating it, such as that the interest rate won’t change over the life of the loan.

Of course, this is unlikely in the real world. Interest rates can move up or down in response to decisions by the Reserve Bank of Australia (actual or anticipated), or simply because the bank’s cost of doing business demands it.

What’s more, when lenders calculate their comparison rates, the inputs they plug in won’t match your own, meaning the rate will only be exactly true of the example given by your lender.

For home loans, the comparison rate is typically calculated on loan amounts of $150,000 and loan terms of 25 years, with principal and interest repayments made monthly. This is much smaller than the average mortgage size in Australia.

Car loans are usually based on a $30,000 loan over a 5 year term, while personal loans are generally based on a $10,000 loan over a period of 3 years, unless stated otherwise.

So while the comparison rate is useful for working out which loans are more competitive and making sure you’re comparing apples with apples, make sure to chat with your lender or use a financial calculator to find the dollar amount you’ll pay.

The idea behind the comparison rate is to give you a more accurate idea of how much a home loan will cost. Without it, lenders could hide any fees and extra charges behind a seemingly inexpensive rate.

By standardising the cost of a loan, the comparison rate makes it much easier to compare different offers from a range of lenders.

For example, Lender A might offer a loan with a 6.40% p.a. interest rate and a 6.50% p.a. comparison rate, meaning the fees and extra charges add an extra 0.10% p.a. to the loan.

Meanwhile, Lender B advertises a loan with a 6.30% p.a. interest rate but with fees equating to 0.40% p.a. of the loan, giving us a comparison rate of 6.70% p.a.

If we only took the interest rate into consideration, we’d be left thinking that Lender B had the more competitive offer. But the comparison rate shows us we’d be better off opting for Lender A, at least in terms of cost.

Even a slight difference in interest rates can mean thousands of dollars saved, not to mention being debt-free sooner than you would if you were paying a higher rate.