How banks calculated interest rates

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How banks calculated interest rates

The price we are charged for most products is the price we pay.

Even with taxes and fees, that's supposed to be the case. The law in Australia requires anyone selling anything to display a total price that encompasses 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 in our own mortgage documents, show that this is hardly ever the case for home loans.

Even though we are both educated as accountants, until recently we hadn't bothered to check interest rates - 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 view the right thing, for banks to do.

Quoted prices are usually not paid.

mortgage interest is typically charged monthly, but the rates are yearly. Each time interest is charged, the outstanding amount is compounded as interest is applied to interest.

But this isn't our main complaint.

The amount of interest can be calculated by two methods. The most reasonable method would be to calculate the daily amount in a way that adds up to an annual amount that matches what was quoted. A 5 per cent rate would really be 5 per cent.

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

The other, albeit less reasonable, way to go about it is called the'simple' method. Our investigations show 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 requires dividing the annual rate by 365 to determine the daily rate.

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

If you borrow $100 for one year at an annual rate of 5 per cent, you will receive a full repayment at the end of the year.

If you were to pay back 105,000, you would expect to receive the money back. The banks' method of calculating interest results in a total repayment of $105,116.

The daily interest rate is applied to the outstanding balance and added to your balance once a month. In New South Wales, 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' calculations and the fine print of their mortgage contracts require a monthly payment of $4,473, including the repayment of the amount originally borrowed over the life of a 30-year loan.

If you paid 59.95 percent per year, the monthly payment would be $4,398 - a difference of $900 per year.

In this typical example, the difference over the life of the loan amounts to about $27,000. The lenders will soon have to pay an effective interest rate of 6.11 per cent.

We had to read the fine print.

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

They charge interest using the'simple' method.

Mutual banks - the 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. We found they used the same method as the big four.

You can find this 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.

The price listed should be the price paid.

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

If you are told that you'll be charged $5.95 per cent interest per year, you should be charged $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. In this respect, honesty and clear communication are even more important.

It's important to know what you will be paying for if you're signing up for a mortgage. Then, 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 first appeared on this piece.