Many people rarely, mention the words “saving” or “investing” as part of their budget. These very same people are often familiar with the word “debt”. My view is that you cannot eat both the fruit and the seed. This is a very important notion that applies in the financial world as well. With household debt now more than R 1 trillion, and with more than 20 million South Africans in debt, it is vital to understand the different types of credit and their cost.
Two important factors distinguishing loans are the term and the interest rate charged.
The term is the number of years over which the loan is paid back. The interest rate may be linked to the prime interest rate or the Repo Rate (RR). The Repo Rate is the lending rate charged by the reserve bank to the commercial banks. The interest rate will broadly indicate the cost of the loan.
Now turning to the actual loans…
Short term and mid term borrowing
These loans are normally given for a period of less than 5 years. For the examples i give below, let’s assume the repo rate is 7%.
Unsecured credit transactions: These include personal loans (also known as medium-term loans), the maximum interest rate one would pay is 28%(=RR + 21% per year).
Credit facilities: These include credit cards, bank overdrafts, revolving credit, the maximum interest rate is 21%(=RR+14% per year).
Incidental credit agreements: Interest rate is 2% per month. This includes the likes of your cell phone contract and other bills handed over to lawyers or debt collectors to collect money on behalf of the credit providers. Once the arrears of the service agreements accumulate and the account is handed over, it is no longer considered as a service agreement but an incidental credit and interest rates are charged at 2% per month.
Micro loan: Repayable over a period of 1-6 months. These kinds of agreements are considered short-term debts and toxic debts. The interest rates are higher, as such loans are repayable over a shorter period of time. Such agreements have maximum interest rates of 5% per month. lf you take this loan every month, from January to December, your total interest rate would be more than 60%.
Long- term borrowing
There are fewer types of long-term borrowing. These include Home loans or mortgages, also known as bonds. A bond – from the word bondage – is secured debt. Secured means that if you fail t pay, the bank has right to possess the property you bought with the loan. Such agreements have a maximum interest of 19%=(RR+12% per year).
Other forms of long-term borrowing – in other parts of the world – include second charge loans or secured loans, which are also loans secured against a property. “Equity release mortgages” are growing in popularity in South Africa. These are designed for older people.
Financial dependency on credit is generally a sign of financial instability, which in return reduces your appetite to save. Saving and investing should be considered as a financial opportunity which will generate a return. Therefore, one should be hungry to save and accept either the long or short-term risk involved with their investment vehicle.
On the other hand, debts are seen as an obligation, since they carry cost and financial consequences.
It is advisable to only get a loan if you know you can afford the repayments and have done an appropriate allocating on your budgets. It is unwise to only budget after you have taken out debt, rather take debt after doing your budget.