AFN - Borrowers Guide to the Comparison Rate Legislation

Background

Until 1 July 2003, there were no rules or regulations that governed how lenders quoted the interest rate applicable to loan products.

The cost of money is very similar for all lenders whether they are banks, credit unions, mortgage securitisation programs, etc. The costs of approving, settling and managing a loan are also very similar regardless of the lending organisation.

In order to gain a competitive advantage in the market place, many lenders resorted to marketing ploys in order to attract and retain borrowers. These ploys included -

• Honeymoon rates - a discounted/lower than market variable rate for an initial period of say 12 months after which the rate reverts to the standard variable rate.

• Discounted fixed rates for a period of 6 to 12 months after which the loan rate reverts to a higher ongoing rate.

• A low nominal rate of interest, however, the rate is effectively increased by imposing account keeping fees and transaction fees.

Which Interest Rate?

Interest rates can be expressed in a number of different ways. The most common are:

Nominal rate is the interest rate at which the loan interest is calculated, e.g. 7.25% per annum. It does not include any loan establishment or management costs.

Average Annual Percentage Rate (AAPR) includes the nominal interest rate and known costs such as loan establishment fees, account fees, transaction costs, etc. 

Effective Rate including Charges (ERIC) is calculated on the interest rate, establishment, account keeping and transaction charges. This rate cannot be calculated in advance as it is dependent on how often the client uses facilities such as redraw, ATM, cheque usage, etc.

Confused?

Over the last 10 years, as the finance industry has become more competitive and loans have become commoditised, there has been undue focus on interest rate as a means of gaining consumer interest.

If you are confused, you are not alone.  Many lenders and most advisers don't know the difference either.

The Comparison Rate legislation is an attempt to help borrowers see through the "smoke and mirrors" of lenders” advertising and provide a means of comparing "apples with apples" - or at least comparing the interest rates on loans. 

The legislation is an adjunct to the Uniform Consumer Credit Code (UCCC). The legislation became effective on 1 July 2003 for a period of three (3) years.  At the end of the three year trial period, the legislation was to be either extended or dropped.   In July 2006, it was extended for a further 12 months and in April 2007 was extended until July 2009.

The law only extends to loans that fall under the UCCC and does not apply to -

• Unregulated credit - where the usage is predominantly for investment or business.

• Continuing credit contracts, e.g. Line of Credit facilities and credit card facilities.

Under the legislation, all lenders must quote a Comparison Rate Schedule (CRS) if they advertise a loan interest rate or a repayment on a loan. This includes radio, television and on websites. If an application form is posted to you, it must be accompanied by a CRS. 

Mortgage brokers are also covered under the legislation and, if they represent more than 6 credit providers, they must display the Comparison Rate Schedules for the 6 credit providers with whom they deal most regularly.

What Costs must be Included in the Comparison Rate?

Fees and charges must be included if they are ascertainable at the time the comparison rate (CR) is disclosed. These fees include -

• Loan establishment

• Valuation

• Documentation

• Monthly account keeping fees

Fees that are not required to be included in the CR calculation are those that are not ascertainable at the time or are dependent upon some future event that may or may not happen. Examples of these fees are - 

• Solicitors search fees, costs and other disbursements incurred in settling a loan, as these will vary from loan to loan.

• Early termination fees and deferred administration fees.

• Transaction fees such as redraw charges.

What does this mean to Borrowers?

Borrowers now have an additional tool to compare loan products, based purely on apparent pricing. However, it is likely that there will abuse of the legislation by lenders, i.e. - 

• Designing products so that there are few ascertainable costs and a greater number/amount of non-ascertainable costs such as transaction fees.

• Greater emphasis on marketing products such as Line of Credit facilities which are exempt from the legislation.

• Increased offerings of "packaged' products where fees and charges are only applicable if future events occur, e.g. your borrowings drop below a specified level.

 
A Practical Application

In the table below we compare a loan from a major lender (with a 1 year introductory rate) with our AFN LinkLoan.    

	Major Lender	AFN Link Loan
Loan Amount	$300,000	$300,000
Term in Years	30	30
Rate Year 1	6.99%	7.55%
Rate thereafter	8.07%	7.55%
Setup Fees	$800	$1,125
Monthly Fees	$10	$0
Comparison Rate	8.03%	7.59%

In Summary

The CR legislation is well intentioned and provides partial assistance to borrowers. Similar legislation has been in place in the UK, USA and New Zealand for many years.

• In the US where the majority of loans are long term fixed rate facilities, the legislation is marginally more applicable.

• In NZ, where the legislation had been in place for 10 years, it has been dropped. 

It is important to understand that the Comparison Rate is only one of the criteria that should be used in evaluating a loan facility.

Non-ascertainable ongoing fees and charges can add significantly to the costs.  It is a little like comparing a $60,000 motor car with a $55,000 4WD and ignoring the running costs of each.

When we buy a home, a car or a computer, we certainly look at pricing. However, we also look closely at the features, how they will help us to achieve our goals, the ongoing costs and customer service.   

Home loans are no different.

Note:  The information contained in this document is of a general nature. Interest rates are correct at the date of publication however are subject to change at any time without notice, and this may affect the calculations in any examples contained in the document. Loan features may also change from time to time. Information contained in Loan Proposals & security documentation supersedes this document. Other terms & conditions may also apply.