What is a Comparison Rate?
Last week we discussed annual percentage rate and reference rate.
This week let us take a look at comparison rate. When you borrow money from a bank or any other financial institution, they charge not only interest but also impose several other fees and charges which make the cost of borrowing higher than the interest.
In addition, these fees and charges differ from bank to bank both in terms of number of fees and charges as well as amounts charged. Therefore, although a number of banks might offer loans at the same interest rate, the true cost of borrowing from them will be different. This true cost of borrowing is usually not revealed to you as a consumer.
A comparison rate is basically the effective rate. It is a rate which includes both the interest rate and fees and charges relating to a loan, reduced to a single percentage figure. For example, a bank's advertised interest rate may be 7.12 per cent but its comparison rate is 7.45 per cent. (Or the actual rate that you will be paying at is 7.45 per cent).
Interest rate alone is therefore not a very good basis for comparing the cost of borrowing from different banks. To make you aware of this, the pre-contractual statement may also include the comparison rate.
What does comparison rate mean in simple terms?
The easiest way to explain comparison rates is to give an example:
In the third example above the quoted interest rate is 10 per cent which attracts $1,000 in interest per year (10,000 x 10 per cent). The fees are $100 per year. This means a total payment of interest and fees of $1,100 per year, which is the equivalent of paying 11 per cent interest (1,100/10,000) as in the second example.
Therefore, in the third example above, the interest rate is 10 per cent while the comparison rate is 11 per cent.
How do we calculate the comparison rate?
The formula for calculating the comparison rate, however, is so complex that most of you are unlikely to understand how it is calculated and what it means.
The comparison rate is calculated in accordance with a standard formula, specified by the regulations. The calculation according to this formula is normally done by computers. Basically, this formula takes into account:
* The amount borrowed
* The term of the loan
* The frequency of repayments
* The interest rate, and
* Ascertainable fees and charges connected with the loan except for government charges.
What costs does the comparison rate include?
* Nominal interest rate
* Loan approval and any other up-front fees
* Known ongoing fees
What does the comparison rate exclude?
* Government and statutory fees (eg mortgage registration, stamp duty and value added tax) - as these are standard regardless of lender or loan type
* Insurance products like comprehensive car insurance premiums.
* Fees and charges that are event-based and may or may not apply throughout the life of your loan eg statement fees or early repayment fees.
So next time when you are intending to buy something on credit, try to compare the comparison rates rather than being satisfied with knowing various financial institutions interest rate only. Remember interest rate alone will not give you a true picture of your financial obligations. It is the comparison rate that has the whole package.
* This is a weekly contribution from the Consumer Council of Fiji