Anyone looking at taking out a loan will notice that there are two rates that appear – an interest rate and a comparison rate. While most people understand the purpose of the interest rate, it can be confusing to comprehend how it differs from the comparison rate. Let’s break it down to properly understand the difference.
First, what is the difference?
There’s one key difference that is important to keep in mind when you’re talking about an interest rate versus a comparison rate. An interest rate is the amount of interest due per period (generally calculated on an annual basis). On the other hand, a comparison rate provides an overview of the actual cost of a loan, so it takes into account the interest rate as well as a number of additional, unavoidable fees1 that are always incurred when taking out a loan.
Why must a comparison rate be included?
As a legal requirement of advertising, any time an interest rate is promoted, a comparison rate must accompany it1. This is a law that all lenders must comply with.
Pros of a comparison rate
Unlike an interest rate, a comparison rate provides more information so you can make a more informed decision about which loan has the best rate. In most cases, a comparison rate will account for application, pre-approval, legal, settlement and monthly or annual service fees1.
When it comes to comparing loans, you don’t just want to consider the interest rate. There are many situations where the interest rate could be really great but the comparison rate is significantly higher. If you disregard the comparison rate, you could get a shock when you start to see just how much the loan will cost you straight off the bat.
A comparison rate might be a legal requirement of advertising, but it’s also a handy tool to use, so pay close attention to it.
Cons of a comparison rate
There are a few things to be aware of when considering a comparison rate, as it doesn’t account for absolutely everything. While unavoidable fees are incorporated into the rate, there are some fees that aren’t, namely those that are dependent on your individual situation. For instance, government fees (such as stamp duty for residential loans) and lenders mortgage insurance (also only applicable on residential loans) are not accounted for in a comparison rate1. Ensure you take note of these extra fees and factor them into your decision.
It's also important to be mindful of how the comparison rate doesn’t consider that the interest rate is subject to change over time. As we all know, interest rates can fluctuate greatly, so it can be hard to account for this factor when calculating a comparison rate. This means lenders will use the rate as it is at the time of taking out the loan to determine what the comparison rate is1. While factoring the comparison rate into your decision is handy, you also shouldn’t solely rely on it to give you the most reliable information.
Evidently, a comparison rate does not take into account each individual’s personal financial situation. One thing you should keep in mind and may not be aware of is that lenders will calculate a comparison rate off a certain loan amount, which is often always significantly lower than the amount most people borrow. All of these factors are always acknowledged when a comparison rate is quoted, so don’t forget to check the fine print – this will help you determine how much weight you give the comparison rate when it comes to making your final decision.
Moral of the story
When it comes to deciding which loan offers the best deal, keep all of this information in mind, but don’t let the comparison rate be the sole factor that dictates your decision. After all, taking out a loan is a big decision so you want to take everything into consideration.
General Advice Warning: This information is intended to be general in nature and is not personal financial advice. It does not take into account your objectives, financial situation or needs. Before acting on any information in this article, you should consider the appropriateness of the information provided. In particular, you should seek independent financial advice.
Source:
1Niko Iliakis, 2022, What is a comparison rate and how is it calculated, Mozo,