Last week we introduced comparison rate and emphasised how important it is to consider comparison rate when buying things on credit as it helps you to identify the true cost of a loan. It factors in the interest rate, fees and charges and displays a single percentage rate that can be used to compare various loans from different lenders.
It is possible to have a great interest rate but if there are lots of fees and charges, it will effectively make the interest rate not the best.
The law also says that if an advertisement includes a comparison rate it must also include a warning that the comparison rate is accurate only for the example given in the advertisement. In other words while interest rate can be the same for all items, comparison rate differs for every item bought. This is mainly because the comparison rates comprise fees and charges together with interest rates.
Can comparison rates be misleading?
A comparison rate can be useful in determining if one loan has more fees and charges than a similar loan. However, the issue with comparison rates is that they assume that the loan will run for its full term.
Take the following example: Refer to graph 1. Assuming interest rates are the same, Loan A looks more attractive as it has less fees over the life of the loan. However, most loans dont last the full 30 years. In the above example, if you kept the loan for less than six years, Loan B would look more attractive than Loan A because the total fees will be less than $600.
Comparison rates do not include early termination fees that may be included with the loan as it is assumed you will be keeping the loan for the full 30 years.
Why is a loan amount always quoted with a comparison rate?
A comparison rate is only valid for the loan amount quoted. The higher the loan amount the less significant the fees and charges become.
Take the following example: Refer to graph 2.
As shown, a $100 fee on a $10,000 loan (100/10000) is relatively much higher than a $100 fee on a $100,000 loan (100/100000).
The above example is very simple, just to help you to understand how the comparison rate is calculated and why it is normally different from the interest rate.
In practice, there will be numerous loan amounts, numerous fees and charges and varying terms of loans, which make it virtually impossible for you to calculate the comparison rate.
For this reason the lenders under the law are required to provide the comparison rates before entering into a credit contract. These comparison rates should also contain a warning which should read as:
Care should be taken in using this comparison rate.
Difference between contracts and variations perimitted during the period of a contract, can detract from its usefulness or even lead to a false impression.
Hence, you as the buyer should also be given a copy of comparison rate by your lender. If the comparison rate is in writing, a warning should be given to you in writing.
Are comparison rates useful?
Comparison rates can be useful in determining which loan is better, provided the loan amounts, length of time for which money is borrowed (term of the loan), and other terms and conditions of the loans are very similar. If any of these, for example loan amounts is different as shown above, the comparison rates will also be different, although the interest rate and fees are identical. Also, the comparison rate will change if the borrower pays off the loan earlier than the full term of the loan. It is for these reasons the lender must provide comparison rates to avoid any confusion.
What is a comparison rate schedule?
A comparison rate schedule details the various rates that apply to the lenders products at various loan terms and various loan amounts.
Example: Car Loan Comparison Rate Schedule. When choosing a car loan, for example, there is a wide variety of different factors that should be considered to ensure you choose the right type of loan. Besides interest rates, you need to consider other costs such as upfront and ongoing fees charges which add to the cost of your loan over the loan term. These costs can vary between lenders and loans, so how do you make sure you are comparing apples with apples. You can do this by using the comparison rates provided by the lender prior to signing your credit contract.
With the above mentioned explanation on comparison rate, you can realise its importance. Once again it is advisable to ask for both the interest and comparison rate as pre-contractual disclosure before buying items on credit. A comparison rate will give you a true picture of your financial obligation over your credit or loan.
* This is a weekly contribution from the Consumer Council of Fiji.