It is almost impossible for most people to live completely debt-free. But the question is: how detrimental is debt accumulation to your financial future? According to Shane Lavagna-Slater, deputy head of department for the faculty of Management and Leadership at Milpark Business School, not all debt is equal…
"There are two different ways in which people can take out a loan contract — either with a secured loan or an unsecured loan. Secured debt is where a credit or a loan is granted by a credit provider in which the borrower pledges some asset as collateral. Examples include a car or property where, if the borrower fails to repay the debt, the credit provider has the legal right to repossess the car or property and recoup at least some of the debt outstanding — in this way the risk of loss of the entire loan by the credit provider is decreased through the collateral pledged.
"Unsecured lending is credit provision without the security of collateral. Examples include credit card debt, personal loans and bank overdrafts. If the borrower fails to repay their debt, the credit provider cannot repossess assets of the borrower immediately. There are lengthy legal proceedings that the credit provider must peruse to recoup their loan. This makes unsecured lending riskier for the credit provider and for this reason unsecured lending is more expensive than secured lending."
Unsecured lending might carry an interest charge of up to 31 percent per annum. This 31 percent is the maximum allowable interest rate prescribed through the National Credit Act and this rate is based on the repo rate (RR) — with the following formula: (RR x 2.2.) + 20 percent per year.
Therefore, as the repo rate rises, new unsecured loans may be priced at a higher rate. Lavagna-Slater says that it is important to note that, when the repo rate rises, already existing unsecured loans may not be charged at a higher or new rate unless this is explicitly stated in the loan contract.
However, the interest rates are only one cost attached to unsecured loans. Other fees include monthly fees, initiation fees and credit life insurance premiums. The National Credit Act regulates these fees and the maximum monthly and initiation fees are R57 and R1140 respectively (inclusive of VAT). The distinction between these is that the monthly fees are added to each instalment monthly, but initiation fees are amortized over the life of the loan which means that initiation fees therefore attract an interest charge over the life of the loan.
A credit provider can also insist that a borrower takes out insurance that covers the credit and maintain it for the duration of the agreement. Credit life insurance premiums are usually between R10 and R15 per R1000 covered, so if the average is taken at R12.50 per R1000 covered, a loan of R10 000 could attract a monthly insurance premium of up to R125 per month.
"The cost of credit (total costs repaid by the borrower) for an unsecured loan of R10 000, with monthly and initiation fees, and credit life insurance, can easily be higher than 50 percent — meaning that a total repaid by the client on a R10 000 loan could be above R15 000," warns Lavagna-Slater.
Despite their high cost we have experienced a rise in unsecured loans in South Africa — as verified by research prepared for the National Credit Regulator (NCR) which states that there has been a year-on-year growth in unsecured loans of 49.4 percent.
According to Lavigna-Slater, the underlying problem with unsecured loans is not the general market exposure to risky loans, but rather the individual exposure to expensive debt.
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