Is there a 'true rate' for a home loan? Yes and no

In April this year, Australian Federal and State Governments introduced a law requiring banks and other lenders to use the Annualised Average Percentage Rate (AAPR) when advertising their interest rates. 

The AAPR is a standardised formula that has been designed to help consumers compare the cost of different loans. 

What does this mean for consumers?

The AAPR will stop you scratching your head, trying to compare advertised interest rates while taking into account different costs and fees associated with different loan options. This is because the AAPR factors in a number of variables to make loan options roughly comparable. This is done by trying to take into account all costs associated with taking out a loan including the interest rate. Such costs would include application and valuation fees and monthly account keeping fees. 

The AAPR is calculated to produce the interest rate that would produce a similar outcome if no fees were charged. That way you can compare apples with oranges, loans with fees on them to loans without fees on them - or with different fees. In short, comparing the AAPR's of two similar loans will usually give a better idea, than comparing advertised interest rates, of which loan is the cheapest.

The AAPR also helps consumers see through the attractions of 'honeymoon' rates. Not surprisingly when one year of honeymoon is followed by years of 'hangover' the AAPR 'true' interest rate comes out higher than a 'basic variable' rate without a honeymoon. 

Limitations of the AAPR

Although requiring lenders to advertise AAPR rates whenever advertising interest rates is in consumers' interests of consumers it is important to understand the limitations of the AAPR.  The AAPR calculations are based upon a standard set of assumptions about the size, term and conditions of the loan. If the size and term of your loan varies from these benchmarks, the AAPR may be less meaningful to you. 

Let's look more closely at three instances in which the AAPR may not accurately reflect your situation.

Different size of loan

In advertising, a standard size loan is used - $250,000. That means advertised AAPRs could be quite misleading for people with a much smaller or larger loan. Standard bank fees of $600 plus $8 per month are pretty hefty on a $100,000 loan, but count for much less if you're borrowing $400,000. 

Different Term of Loan

The AAPR is calculated over seven years. If one had to pick a period, this isn't a bad period to choose. But if you want to look over a shorter or longer period, this will change the calculations. Generally the longer the loan lasts, the less important 'once off' valuation and application fees are. 

This limitation of the AAPR can be overcome. While there are other service providers out there who have calculators on which you can specify the size of your loan and the fees charged, we're the only service provider we know of who'll let you specify the period you want your AAPR calculation done over. 

If you want to run a scenario that best fits your personal situation and the term of your loan, it is worth having a look at our AAPR or true rate calculator. If you are in the process of getting a loan through us we can email this to you if you e-mail us at . A word of warning however. Its usually a mistake to put in 25 or 30 years - the term of most loans. Although you won't be forced to pay your loan off any faster, you should check the market every now and then as new products emerge, competition continues to intensify and margins tighten. 

Remember, even if you don't plan to refinance your mortgage, you'd be surprised how often people are forced to do so - they move to a larger house, move cities and so on. We think 5 years is a long time to apply the AAPR, but most people shouldn't set it for longer than 10 years.

Variable rate loans

If you have a variable rate loan, the AAPR may not accurately reflect the cost of this loan over time. This is because the AAPR can only be calculated by reference to the initial rate. However, it still does help when comparing two variable rate loans providing their interest rates relative to each other don't change. 

Some other tips

It is also important to remember that the cheapest loan is not necessarily the best loan for you. Some loans with the lowest AAPRs may have no-frills or additional features. This type of loan may be perfect for some borrowers. However, many people want and need the flexibility provided by features such as portability or an offset or redraw facility.  

These features do cost extra but increase flexibility and are worthwhile for some consumers - either because they save hassles, or money over the longer run. The AAPR cannot value the benefits, convenience or flexibility you get from these extras. Only you can do that. The AAPR also does not factor in the cost of redraw fees. If you want to build these in, try to work out how much you'd use a redraw each year convert this amount into a monthly fee and then use our calculator to calculate the AAPR. 

The AAPR does factor in the higher rate of interest you usually need to pay on loans with an offset facility. However, it cannot take into account savings resulting from any reduction in the loan balance provided by the offset facility. You might think that the savings associated with the offset facility are worth paying for. A word of warning - our first Newsletter shows that the amount saved by reducing your loan balance is often much less than the cost of the higher interest rate associated with an offset facility. 

Our next newsletter (forthcoming) talks about obtaining lines of credit from lenders, how they work and why they often cost more than a basic variable interest rate loan. The good news is that the AAPR will highlight these increased costs. The better news is that our next newsletter contains some tips about where to get a discount on your line of credit and other options to increase funds at your disposal. (Contact us if you want an advance copy)

If you firmly believe that the customer is king you will need to find a loan provider who feels the same way. Once again, the AAPR cannot help you decide who will provide the best service over the life of the loan. A large organisation with plenty of resources may be in a good position to provide great service, but we all know that this does not always hold true. Sometimes you can only go on instinct or gut reaction. It is worth checking opening and after-hours service and telephone and internet service options. Word of mouth may provide further guidance. Feel free to ask us what our experience is. 

Good service is important for peace of mind. It is particularly important if you have a fixed settlement date that your lender works to that end. Last minute panic because the paperwork is not in order is surprisingly common. The lender may have overlooked a missing document or may belatedly discover it is not satisfied with the borrower's income level. Settlements rarely fall over but it can happen, and last minute stresses will be avoided (usually!) with the right service provider. 

So finally, the AAPR is a step in the right direction for consumers. But the buyer still needs to beware. Think carefully about the extra features not covered by the AAPR and take the time to run your own personal details through a software package such as our true rate calculator.

Cheers


AKA Nicholas Gruen  

July 2002

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.