03 Sep Is the interest rate the best way to compare loans?

“What’s the rate?” It’s easily the most common question I get asked.

We’re supposed to use “comparison” rates to compare financiers. A comparison rate is just another way of saying effective rate.

An effective rate is an interest rate that accounts for “all costs” that are loaded into the loan cost (account keeping fees, risk assurance charges, documentation fees that are financed etc.)

Problem is you may have noticed on websites that quote a comparison rates, there is always an *.

Below this there is usually something that says, “Comparison Rates based on $30,000 over 5 years.” Or something to similar effect.

But what if you are not getting a loan of $30,000? Then that rate doesn’t apply to you. How are you supposed to compare?

To keep it simple, by law, you can use certain pre-set amounts. $30,000 seems to be most common in our space. So that’s most likely the only figure you’ll ever get to compare.

There is a legitimate reason behind why this is the case. It’s because the maths is complicated. A term of 5 years will have a different comparison rate to 4 years if there are any fees involved.

So for a simple question like “What’s the rate?” you end up having this give 5-7 different answers.

And without the term and amount you can’t give you an exact answer. And even then you need to use a calculator to figure it out. There isn’t one easy answer to the question.

Telling people the above usually frustrates them as they think you are not giving them a straight answer.

So what most people in the finance industry do to combat this is quote the base rate.

The base rate is the interest rate before fees. It, unlike the effective rate is the same across all terms, so you can memorise a few of them.

Most of the times fees across all platforms are similar. So comparing base rates is still an effective way of comparing.

But there are problems with this method as well.

People have clued on that rate is the only thing anyone cares about. So why don’t we charge 0% interest and a sh*t load of fees? Sound familiar?

Whichever way you look at it. When you are comparing interest rates, you are probably not comparing apples with apples.

The only way to compare properly is to look at the total dollar cost.

You pay in $ signs, not % signs.

Let’s say you take a $100,000 loan out at 10% per annum over 5 years (60 months).

That works out to be $2,107.14 per month.

Or a total of $126,428.40 ($2,107.14*60).

So the “cost” to you is $26,428.40

When you go shopping around, compare the $26,428.40 not the 10%.