How banks calculate interest rates

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How banks calculate interest rates

For most things we buy, the price we pay is the price we receive.

Even with taxes and fees, it's supposed to be the case. A total price of anything sold in Australia must be shown to anyone who sells it, including all 'taxes, duties and all unavoidable or pre-selected extra fees'.

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

Even though we are both educated accountants, until recently, we hadn't bothered to check - even as interest rates climbed. We expected 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 rate of mortgage interest is usually monthly, but the rates are yearly. When interest is charged, the outstanding amount of interest is compounded as interest is applied to interest.

But this isn't our main complaint.

How do you calculate interest rates? The most reasonable would be to calculate the daily amount in a way that adds up to an annual amount that matches what was quoted. If the rate is 5 percent, a 5 percent rate would really be 5 percent.

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

The other, arguably less rational, way to do it is called 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 known as the simple method because it involves simplydividing the annual rate by 365 to determine the daily rate.

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

If you borrowed $100,000 for a year at a rate of 5 per cent, you will be paid back the entire amount at the end of the year.

If you make a $100 loan, you can expect to pay back $105,000. The banks' methods for calculating interest returns resulted in a total repayment of $105,116.

The monthly interest rate is applied to the outstanding balance and is 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 deals require a monthly payment of $4,473 including the repayment of the amount originally owed over the life of a 30-year loan.

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

The difference over the life of the loan amounts to about $27,000, according to this typical example. This means that these borrowers will end up paying an effective interest rate of 6.11 per cent.

We had to read the fine print.

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

All charges interest using the'simple' method.

Mutual banks - old 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 go, we discovered that they employed the same method as the big four.

You can easily find this small print yourself, usually in the middle of your mortgage documents. 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 that the price of a product should be the actual price, as the law requires for products other than mortgages.

This means if you're told you'll 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.

The cost of buying a mortgage is higher than buying a home. The importance of honesty and clear communication is especially significant in this regard.

When signing up for a mortgage, it's crucial to know what you're letting yourself in for. When the bank or broker explain 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 was first broadcast about this piece.