So I recently completed a refinance. It took me over 3 months from contacting the broker to the day the account is created. I just want to share some thoughts on the difference between interest rate and comparison rate. And when one is more beneficial than the other.
- Interest rate is the pure rate charged on outstanding loan balance.
- Comparison rate is interest rate plus certain fees, defined by the banks.
- If your goal is to smash the loan as fast as possible, high comparison rate is not really an issue.
- If your goal is to keep the loan for as long as possible, give some thoughts to the comparison rate.
Interest rate vs comparison rate
This is an example of loan package that outline the interest rate and comparison rate, along with the fees associated.
One thing to note is that when calculating comparison rate, banks like to use these figures: $150,000 loan size, 25 years loan, Principle & Interest payment.
As we can see, the interest rate is 3.84% per annum, which means for a loan of $150,000, you need to pay $779 per month in mortgage.
However, looking at the comparison rate, it is 4.24% per annum, essentially means you need to pay roughly $812 per month in mortgage.
The difference for a year is roughly $395, which equals to the annual fee that they note down in the image above. The fee could be higher if the banks also calculate the account opening fee into the comparison rate.
When do we need the lowest comparison rate?
This is a bit weird for people like me who just got into property investment. But for investment properties, I want to drag the loan out as long as I can, so I can utilize the borrowed money to keep purchasing. I am willing to pay interest only for as long as I can, because it makes the cash flow better and more predictable.
With that in mind, obviously the higher rate is, the worse the cashflow will be for an investment property. So when I try to find a loan, it is in my interest to find something that has a low comparison rate, only if I intend to hold the loan for a long time.
So when do we want a high comparison rate?
Home loans often have the best interest rate, but sometimes go with a terrible comparison rate because of all the fees associated with it.
However, if my intention is to pay it out in the next, say 10 to 12 years (surprisingly, it is not that impossible to do). I can take the package with low interest rate, but a bit high comparison rate. The reason is that comparison rate is calculated based on a gradual payments for a long time. So by paying extra and/or change the payment period, we can reduce the real rate down to a ridiculous amount.
Example: given the same rates above, let’s say that we want to pay $300 per week into the repayment. With the assistance of moneysmart website, we can calculate the total repayments and how long does it take, as well as guessing the actual comparison rate.
As we can see, by paying extra into the home loan with the intention to finish it off, the actual rate is even less than the interest rate, since we finish the loan much earlier than expected of 25 years.
Loans are complicated, and there are a lot more that I cannot cover. It is best to go to a broker and discuss with them your goal. Trust in their expertise to find a perfect loan for you. And if things don’t work out the way you want, a refinance is always an option.
By Tuan Nguyen