Interest Rate vs. Comparison Rate: The Critical Difference Every Borrower Must Understand
When shopping for a home loan, you’ll likely see two numbers side-by-side: the advertised Interest Rate and the legally required Comparison Rate. While they may look similar, they serve very different purposes. Understanding the distinction is crucial to avoid hidden costs and find the true cost of a loan.
The Headline Number: The Interest Rate
- What it is: This is the base annual cost of borrowing money from the lender, expressed as a percentage. It does not include any fees or charges.
- Purpose: It’s used to calculate your regular mortgage repayment amount.
- Example: A $500,000 loan with an interest rate of 6.5% would have an annual interest cost of $32,500 (500,000 x 0.065). This is the number lenders often advertise most prominently to attract customers.
The Limitation: The interest rate alone doesn’t tell the full story. A loan with a low interest rate but high fees could end up being more expensive than a loan with a slightly higher rate and low fees.
The “True Cost” Number: The Comparison Rate
- What it is: A comparison rate is a single percentage figure that combines the interest rate with most of the known fees and charges associated with the loan. It is designed to help you understand the true annual cost of the loan.
- What it includes:
- The interest rate
- Most upfront and ongoing fees (e.g., application fees, annual package fees)
- What it (often) excludes:
- Government fees (like stamp duty)
- Fees that are only charged under certain conditions (e.g., late payment fees, redraw fees, early exit fees)
- Purpose: To provide a more accurate tool for comparing the overall cost of different loans from different lenders. It’s a legal requirement in many countries (like Australia) for lenders to display it alongside the headline rate.
Example: Let’s take two loans for $500,000 over 30 years:
- Loan A: Interest Rate = 6.5%, with $500 in annual fees.
- Loan B: Interest Rate = 6.7%, with no annual fees.
While Loan A has a lower headline rate, its Comparison Rate might be 6.62%, while Loan B’s Comparison Rate might be 6.70%. In this case, Loan A is actually the cheaper option overall when fees are factored in.
This is why the comparison rate is so important—it prevents Loan A from looking deceptively expensive and Loan B from looking deceptively cheap.
Side-by-Side Comparison
| Feature | Interest Rate | Comparison Rate |
|---|---|---|
| What it represents | The base cost of borrowing the money | The “true cost” of the loan, including fees |
| Includes fees? | No | Yes (most upfront and ongoing fees) |
| Purpose | To calculate your regular repayments | To compare the overall cost between different loans |
| How it’s used | “This loan has a rate of 6.5%.” | “Although their rate is 6.5%, the comparison rate is 6.72%, which is higher than another lender’s 6.68%.” |
How to Use This Information: A Practical Guide
- Start with the Interest Rate: Use it to budget your potential monthly repayments.
- Always Check the Comparison Rate: Use this as your primary tool for comparing loans from different lenders. The loan with the lowest comparison rate for the same amount and term is likely to be the cheapest overall.
- Read the Fine Print: Remember, the comparison rate is based on a specific loan amount and term (e.g., $150,000 over 25 years). Ask your broker or lender to calculate a comparison rate for your actual loan amount, as it can change.
- Ask Questions: Specifically ask the lender, “What fees are included in this comparison rate?” and “Are there any fees not included that I should be aware of?”
Conclusion:
Don’t be seduced by the lowest headline interest rate. It’s a teaser rate designed to grab your attention. The comparison rate is your most powerful tool for cutting through the marketing and identifying the loan that will actually cost you the least amount of money in the long run. Always use both numbers together to make a smart and informed borrowing decision.