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Comparison rates mislead and confuse borrowers - Newsletter 2003

All providers of credit products offering fixed term loans (not perpetual loan facilities like credit cards or lines of credit on residential property) are now obliged to produce a figure called a Comparison Rate whenever they quote interest rates in advertising or in communication with clients. This requirement came into force on July 1st 2003, after a number of lenders had earlier adopted a simpler standard - the Annualised Average Percentage Rate (AAPR).

What do comparison rates tell you?

The idea behind both the AAPR and the comparison rate is a good one. Comparing loans has become much more complex as the number of products has proliferated and lenders have imposed ongoing fees in addition to application fees. Comparing loans can be like comparing mobile phone plans! You have to have a PhD to understand them. Actually I have a PhD but I long gave up trying to fight my way through phone plans!

Be that as it may the comparison rate and the AAPR calculate the total range of costs in addition to interest payments. (The main costs are application and other up front costs and account keeping costs). They then produce a single interest rate that is intended to 'take into account' all costs in the loan that cannot be avoided - like application and loan maintenance fees.

When I heard that the governments of Australia were introducing 'comparison rate' regulation I thought this was a good step to help consumers. Unfortunately I was wrong. I thought they would require all lenders to supply AAPR information. If they had done so it would have helped consumers at negligible cost to the industry. The AAPR assumed that borrowers held their loan for 7 years (approximately the average time before paying off or refinancing loans at the time though this has fallen to around 5 years today). It also assumed that loans were $250,000, though the lender could use some other figure.

I explained some of the problems with the AAPR in an earlier newsletter. Generally it is only accurate for a specific loan size and there are lots of fees that are not taken into account in the calculation. Nevertheless the AAPR offered useful assistance for borrowers. And it exposed some of the most misleading practices of lenders, such as selling 'honeymoon' loans to snare people into a loan that was more expensive in the long run than normally priced loans. It produced a single index that allowed reasonable comparisons. It was also easy for lenders or brokers to provide the AAPR at the loan size the client was seeking a loan for. Peach also provided an AAPR that clients could tailor to their own circumstances - making the calculation period as long as the loan term - 25 or 30 years - or as short as 1 year.

This is where my disappointment with the Comparison Rate legislation arose. It seems that, in seeking to address the limitations of the AAPR those introducing Comparison Rates have actually made their reform do the exact opposite of what was intended! Where a simple number helped clients work out what was important for them, Comparison Rates make this more complicated.

The Comparison Rates are provided in large schedules of 15 loan sizes from $10,000 to $300,000. Although of course it is nonsensical to produce figures for a home loan of $10,000, the lenders of Australia are now doing just that. Against this the lenders have many different products. So their Comparison Rate schedules make mobile phone plans look like a paragon of simplicity! When it had to comply with the new regulation St George released a Comparison Rate Schedule with around 460 different interest rates on it! And this is supposed to help borrowers by keeping it simple! The system couldn't be better designed to swamp borrowers in information if it tried!

One of the first reactions to this has simply been the removal of interest rate information from advertisements. We don't have the money to get lawyer's advice on what we can and can't do and its not at all simple. So, following general advice by lawyers to the industry, we now advertise without interest rates. Lots of other lenders have chosen to do the same thing. So now customers get less information, not more as a result of the new regulation. Further there are lots of grey areas. Lines of credit don't require comparison rates, so lenders don't publish them - yet lots of the biggest rip-offs occur with lines of credit. Also the new regulation doesn't seem to require comparison rates for 'professional packages'.

But, as they say on those steak knife ads - 'wait there's more!' Perhaps the designers of the new system felt that the AAPR should not have assumed people held their loan for seven years when lenders offer them for longer. So it seemed more 'accurate' to have the comparison rates calculated over the entire term of the loan.

But doing this goes against the spirit of the new legislation because it dramatically reduces the relative weighting given to up front fees - after all what's $600 or even $1,000 if you're getting a loan for 30 years. A $600 fee increased the AAPR on a $150,000 loan by around .07% whereas it increases the comparative rate by just a little over half that amount. Yet almost everyone will refinance or pay off the loan well before the loan term expires.

If this seems like quibbling, consider the situation with fixed rates. After the fixed rate period is over your loan typically reverts to the standard variable rate - yet most people who fix review their loan at the end of the fixed rate. They may fix again, revert to the standard variable rate to or refinance elsewhere. Yet the Comparison Rate is actually calculated over the entire original loan term.

We were recently drawing our client's attention to what we thought was a great deal for borrowers. Rates fixed for 5 years at 5.99% 'headline' or 'annual rate' (The loan had full access to the flexibility of unlimited capital repayments and even a redraw - which is most unusual for a fixed rate loan but that is another story! Let us know if you want to know where you can find that loan - but its rate has gone up!). Yet the Comparison Rate for the loan was a little under 6.3%. Why? Because the loan would revert to around that level (itself a silly assumption as goodness knows what the 'standard variable rate' will be in five years time). But the standard variable rate of around 6.3% for the last 25 years of the loan "swamped" the lower five year fixed rate. Yet it is the immediate five-year fixed rate that is most important to borrowers - the higher standard variable rate will be incurred well into the future and they can refinance away from it.

In this example the Comparison Rate would have misled many borrowers. But it would have done so by overestimating the true rate they were facing. This is presumably better than underestimating their costs. Borrowers having their rate underestimated may think that their loan is cheaper than it is. If it does not lead them directly into financial difficulties (which is fairly unlikely as one hopes they are looking at the monthly payments they must make at the loan's outset) it can certainly be used to sell clients loan products that will cost them more than alternatives.

Now as fixed rates rise towards their more normal state of being more expensive than variable rates the tables have turned. In the current climate, the formula for comparison rates underestimates the comparative cost of most fixed rate loans. Here the lower variable rate to which the loan reverts after its fixed rate period reduces the significance of the higher fixed rate period given that the variable rate period of the loan is much longer. Government regulation is now misleading borrowers in the worst possible way, making them think loans are cheaper than they are!

The sad part about it is that there's lots more government regulation to come. Because the industry is so poorly regulated, because there is so much deception in the industry, there is continuing political pressure to 'do something'. It treads on too many toes to actually stop the deception in the industry - where firms effectively 'selling' home loans offer themselves to borrowers as 'independent advisors'. So instead, a couple of times a year, a little more red tape is introduced into the industry. Its just what the larger players want - it confuses borrowers, imposes costs and barriers to entry into the industry - and it introduces lots of standards for brokers to comply with. The added complexity means that consumers need more help to sort through all the complexity. And where will the get the help? From brokers selling loans in the guise of 'independent advice'.

Some regulation that governments are now contemplating could introduce hefty compliance requirements whenever brokers write loans with 'offset' accounts for borrowers. If that happens we will probably have to reduce our rebates. But it would not raise standards in the industry - indeed it would enable the larger players to say they were 'licenced' brokers and legitimating their essentially deceptive claim to be independent 'advisors' to borrowers. Sad but true.

And on that happy note, I'll sign off, and wish you well until my next newsletter.

AKA Dr Nicholas Gruen
October 2003

Please note: The observations made here are general and indicative. Nicholas Gruen is not a qualified investment adviser. Further his comments are general and do not take into account your specific circumstances. Nor are they warranted as free from error in any respect whatsoever. You should not rely on any aspect of them without taking independent financial advice relating to your own specific circumstances. We suggest you obtain advice on a fee for service basis rather than from someone who earns either up-front or trailing commissions from investments they recommend. We would be happy to let you know of service providers who provide advice on this basis.

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