How banks calculate interest rates

How banks calculate interest rates

The price we pay for most things is the price we receive.

Even when taxes and fees are involved, that's supposed to be the case. The law requires anyone selling anything to show a total price that includes all 'taxes, duties and all unavoidable or pre-selected extra fees'.

Our investigations, which compare the interest rate quoted on our mortgages with the fine print seen in our own mortgage documents, show that this is hardly ever the case for home loans.

Although we are both trained accountants, until recently we hadn't bothered to check interest rates - even as interest rates skyrocketed. We assumed the rates we were told we were being charged were the rates we were actually paying.

This would be easy enough and in our opinion the right thing for banks to do.

The quoted price is usually not paid.

The monthly interest rate for mortgages is usually one-month, but the rates are yearly. If interest is charged each time, the amount of interest compounded as interest is applied to interest.

But this isn't our main complaint.

Is there a way to calculate interest rates? To calculate the daily amount in a way that adds to an annual amount that matches what was said, the most reasonable would be to calculate the daily amount. A 5 per cent rate would really be 5 per cent.

Although there is a bit of computation involved, it's easy enough for banks to do.

The other, arguably less reasonable, method is the'simple' method. Our investigation shows that this technique is used by all the big four banks, and probably many others too.

The simple method is called the simple method because it requires simply dividing the annual rate by 365 to determine the daily rate.

This seems to not be important, but because of compounding it means that the rate charged over a year is more than the rate quoted.

If you borrow for one year at a rate of 5 percent, you will be able to repay the entire amount at the end of the year.

You can expect to pay back 105,000 if you don't make a payment. The banks' method was to calculate interest results to $105,116 in a total repayment of $105,116.

This is because the daily interest rate is applied to the outstanding balance and added to your balance once a month. In July 2023, the average size of a new mortgage in New South Wales was about $750,000, with an average interest rate of about 5.95 percent.

The banks and the fine print of their mortgage contracts require a monthly payment of $4473 including the repayment of the amount originally borrowed during the life of a 30-year loan.

If the monthly payment were charged at $5.95 per cent annually, the monthly payment would be $4,398 - a difference of $900 per year.

In this example, the difference over the life of the loan amounts to about $27,000. It means theseborrowers will be paid an effective interest rate of 6.11 per cent.

We had to read the fine print.

We scrutinized the terms and conditions of each of the top four banks - Westpac, the Commonwealth, National Australia Bank and the ANZ - as well as their biggest subsidiaries, which include St George, The Bank of Melbourne, Bank SA and Bankwest.

All charges interest using the simple'simple' method.

Mutual banks, the former credit unions and building societies owned by their members, have different reporting requirements, and we were unable to check the terms and conditions used by each one. Where we could, we found that they used the same method as the big four.

You can find this small print yourself, usually in the middle of your mortgage document. It's a formula, accompanied by a paragraph of explanation.

Or you could call customer service, as we did, and ask the bank to explain the calculation.

Quoted price should be paid.

We believe the price charged in a product should be the actual price, as the law generally requires for products other than mortgages.

If you are told you will be charged $5.95 per cent interest per year, you should pay $5.95 per cent per year - not $6.11 per cent because of a quirk in the formula.

mortgages are a bigger financial commitment than most purchases. To ensure this, honesty and clear communication are especially important.

When signing up for a mortgage, it's important to know what you're letting yourself in for. When the bank or broker explains it to you and it's not what was advertised, you can ask for a discount.

Sander De Groote is a lecturer and Kevin Li is a senior lecturer at UNSW Sydney's School of Accounting, Auditing and Taxation. The conversation premiered this piece on July 30.