You see a loan advertised at 7.5% and, in smaller print, a comparison rate of 8.7%. It looks like a typo, but it is not. The gap is deliberate, and it tells you something useful.
Two numbers, two jobs
The interest rate is the price charged on the money you borrow. The comparison rate is a single annual percentage that combines the interest rate with most of the fees and charges that come with the loan, calculated on a standard example loan. Its purpose is to let you compare offers that have different fee structures on a like-for-like basis.
If a loan carried no fees at all, the two numbers would be the same. The more fees it carries, the wider the gap becomes. MoneySmart publishes a plain-language overview of how this works if you want an independent explanation.
A worked example
Let us use a $30,000 loan over five years (60 monthly repayments) at an illustrative 7.5% a year.
Without any fees, the monthly repayment works out at $601.14. Over 60 months you would repay $36,068.31 in total, which means $6,068.31 of interest.
Now add two common charges: a $350 establishment fee paid at the start and a $10 monthly account-keeping fee.
- Establishment fee: $350
- Account fee: $10 × 60 months = $600
- Total fees: $950
Your repayment is now effectively $611.14 a month, and you have paid $350 up front. In total you have handed over $37,018.31 for the use of $30,000, so the real cost of borrowing is $7,018.31, not $6,068.31.
Solve for the single annual rate that equates the money you effectively receive with everything you pay, and you land at about 8.7% a year. That is the figure the comparison rate is trying to capture. The headline rate has not moved at all, yet the effective cost has risen by roughly 1.2 percentage points because of $950 in fees.
Why the size of the loan matters
Fees are fixed dollar amounts, so they hurt smaller loans more. A $350 establishment fee on a $30,000 loan is a little over 1% of the amount borrowed. The same fee on a $10,000 loan is 3.5%. That is why comparison rates for small, short loans can be a long way above the headline rate, and why they should be read alongside the loan size they were calculated on.
What a comparison rate does not tell you
It is a very useful tool, but it has limits.
- It is based on a set example. If your loan amount or term is different, your own effective rate will differ too.
- Some charges may be left out. Fees that depend on your behaviour, such as late-payment fees or early-payout charges, are generally not part of the figure.
- It does not include a balloon in the way you might expect. If a loan has a residual payment at the end, check how the lender has treated it in the calculation.
- It is not a prediction. For a variable-rate loan it reflects the rate on the day, not what happens later.
How to use it well
- Compare like with like. Put quotes for the same amount and term next to each other.
- Ask for the full fee schedule. The comparison rate is a summary; the schedule is the detail.
- Work out the dollars. Multiply the monthly repayment by the number of months, add upfront fees and subtract the amount borrowed. That is your actual cost of credit in dollars.
- Check the maths yourself. The repayment calculator on this site can confirm a lender's stated repayment before you rely on it.
The bottom line
A comparison rate is not designed to confuse you; it exists because a low headline rate can hide a lot of cost in the fine print. When two offers look close, the comparison rate, together with the fee schedule, is usually where the real difference shows up.
This article is general information with illustrative figures. It is not advice or an offer of credit.
