How is comparison rate calculated?

A comparison rate makes it easy to compare mortgage products with different interest rates and fees. To really understand what it means, let's see how it is calculated.
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When it comes to home loans, there are many factors to consider and, if you’re a first-time property buyer, you will encounter a lot of new terms. One of these terms is "comparison rate". It refers to the true cost of a home loan including fees. In this article, we’ve rounded up some of the things that you need to know about the loan comparison rate.

The Australian government requires all lenders, banks, and other financial institutions to advertise a home loan comparison rate. Home buyers can use this to their advantage as they can easily compare home loans being offered by various institutions. Without a comparison rate, it would be difficult to compare home loans because of all the potential variations in interest rates and fees.

You may wonder how a home loan comparison rate is calculated. It uses a formula that considers interest payments plus any additional fees and charges. Obviously, the comparison rate will be a bit higher than the headline interest rate because it takes into account additional costs.

There are 3 main categories of fees that are typically used to calculate a comparison rate:

1. Upfront fees

a) Application fee
b) Preapproval fee
c) Valuation fee
d) Documentation preparation fee
e) Legal fee
f) Settlement fee

2. Ongoing fees

a) Monthly account fee
b) Annual package fee
c) Periodical admin fee

3. Discharge fees

a) Discharge admin fee
b) Documentation preparation fee
c) Settlement fee

A comparison rate is supposed to represent the true cost of having a home loan. It is normally calculated as a $150,000 loan over a 25 year period. Comparison rate will also quickly point out products that offer honeymoon rates e.g. special discounted rate for the first year and then roll it out to a much higher interest rate.

It is important to keep in mind that the home loan with the lowest headline interest rate is not automatically the best deal that you can get. To illustrate: if one home loan offers an interest rate of 3.10 percent, with fees and charges totalling 0.10 percent per annum, the comparison rate will be 3.20 percent. On the other hand, if the second home loan has an interest rate of 3.00 percent, with additional costs of 0.30 percent, the comparison rate is 3.30 percent. Even if the second home loan comes with a lower interest rate, its fees and charges pull the rate up, making it higher than the first home loan with a higher interest rate.

If you’re buying a property, make sure to consider the home loan comparison rate. Even a small change in the interest rate and additional costs can significantly alter the total cost of your home loan as well as the repayments.

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