What do loan comparison rates actually mean?

When you’re buying a home, it can sometimes seem like you’re expected to learn a whole new language.

Property Home House FamilyTerms like “loan to value ratio”, “conditional approval” and “comparison rates” are bandied about on TV ads and in product disclosure statements – and if you don’t understand what they actually mean you could find yourself in a spot of bother when it comes time to sign contracts and shackle yourself to a 30-year financial commitment.

With interest rates at record lows, you’ll start to become familiar with seeing the “comparison rates” popping up all over lender advertising, in addition to the fixed or variable rate associated with the loan product.

But what does a comparison rate even mean – and how can you use it to help you make a smart home loan decision?

Actual rate version comparison rate

These two numbers are different, usually by a few tenths of a percent, but occasionally by up to 1.5%.

ad_build_wealthWhile a few tenths of a percent may not seem like much, when you’re dealing with hundreds of thousands of dollars (plus the impact of compound interest), it means even a tiny difference in interest rates can add up to a huge amount of money over the life of a home loan.

Therefore, it’s pretty important that you know what these rates mean.

So, if not to confuse and befuddle unsuspecting homebuyers as they march towards their goal of home ownership, what is the purpose of comparison rates?

You can thank the Australian Government for introducing comparison rates; they made it mandatory to display comparison rate alongside any interest rate advertised for a credit product, including home loans, back in 2003.

House Model With Pile Of Dollar Bills, Calculator, Pen And Plant Pots On Table With Garden Background For Business, Finance, Banking, And Saving Money.“Comparison rate” is another term for “average annual percentage rate”, and it’s there to help you calculate the true costs of servicing the loan, once all of the fees and charges have been included.

That way, you can compare loans from different lenders and find yourself the best deal – we’ll just pause for a second as you have an “Aha!” moment over why they are called “comparison rates”…

Put simply, when you’re researching home loans, you’ll need to know not only the interest rate payable on the funds you’re borrowing, but also any additional charges like application fees, establishment fees and monthly or yearly account-keeping fees. You’d also need to factor in low introductory rates that revert to higher rates after a few years – is your brain hurting yet?!

This would involve hours of research and wearing out some of the buttons on your calculator to do by yourself.

And, unless you really love maths, your time is probably better spent actually house hunting.

So, the comparison rate takes care of all this for you

You’ll be able to see, at a glance, which loan works out cheaper overall, once all those extra bits and pieces have been considered.

Home LoanSometimes this means that you are better off choosing a loan a slightly higher interest rate, but lower fees and charges, as the one with the lowest advertised interest rate might not actually work out to be the smartest financial option for you in the long run.

Sounds amazing, right?

But wait – there’s a catch!

How accurate the comparison rate is for your unique circumstances will be affected by factors including the fees and charges we mentioned above, as well as the length of the loan, repayment frequency, and how much the loan is for.

Comparison rates are calculated based on principal and interest loans of $150,000, taken out over 25 years.

This is obviously not the standard Aussie home loan, with most of us paying back mortgages several times this amount, and many choosing 30-year terms to lessen the sting of the monthly repayment.

This is probably the most important thing to note about comparison rates – they are true and correct only for the example given, which is likely to be vastly different from your own situation.

Online CalculatorsIt really is about time for comparison rates to be updated with the times, as a comparison around the $500,000 mark would be much more useful to modern borrowers.

All of which is to say…

When considering comparison rates, you still need to be vigilant and use online calculators or check with your broker to ensure the product works well for you.

Comparison rates also don’t take into account charges like break fees, late payment fees or redraw fees.

They also don’t consider how inclusions such as offset accounts or the ability to repay the loan early will impact the overall cost.

When it comes to figuring out how all these variables will affect your home loan, there’s no substitute for sitting down with your accountant or mortgage broker and their trusty calculator, and exploring each possible scenario so you can make the best possible financial decision for you.

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Read more: propertyupdate.com.au