Most of us already know what the interest rate is when talking about loans. However, the comparison rate is less frequently talked about. It was actually created to benefit consumers by allowing them to accurately compare finance products such as home loans or car loans between different banks and non-bank lenders.
Interest rate: A proportion of the loan that is paid by the borrower in addition to the original loan value which is presented as a percentage.
Comparison rate: A summation of the costs incurred from a loan inclusive of interest rate and all additional expenses such as account keeping fees.
Should I look at the interest rate or comparison rate?
The interest rate is no doubt an important aspect of every loan. Generally speaking, the lower, the better. So it’s helpful to know what interest rate is being offered on the loan that you’re considering.
However, because the interest rate alone doesn’t consider additional costs such as account keeping fees, early exit fees etc. It can sometimes be misleading. A lender could offer a loan with a really low interest rate but have excessive additional fees which mean that you end up spending considerably more than expected.
Here’s a simplified example comparing 2 loans:
Loan A has a higher rate and lower fees. Loan B has a lower rate and higher fees. In some circumstances the cost of fees can outweigh the low interest rate. This is an example of that happening.
Interest rate 3%.
5 year term.
Fees and charges = $950
Final cost = 58,913.70
Comparison rate = 3.57%
Interest rate 2.5%.
5 year term.
Fees and charges = $2490
Final cost = 59,060.41
Comparison rate = 3.62%
When considering the comparison rate, it shows us that Loan B is the more expensive loan, despite having a lower interest rate. Without looking at the comparison rate, a borrower may choose Loan B under the impression that it would be the cheaper of the two and then end up spending more compared to Loan A. It’s important to note that lenders don’t advertise the amount of their additional fees, which is why the comparison rate is such an important element in the finance industry.
A good rule of thumb to follow is that the larger the gap there is between the interest rate and the comparison rate, the greater you are getting charged for additional fees. For example, an interest rate of 5% and a comparison rate of 8% for the same loan means you are getting charged a significant amount in fees that are separate from the interest repayments.