May 11, 2003
By Bruce Cameron
At every turn there is someone trying to lend you money – usually to buy things you don’t really need. And to make matters worse, the less you need something, the more you pay in interest charges. Considering how crippling debt can be – with consequences ranging from marital conflict to suicide and, in extreme cases, murder – we have to learn to be more aware of the traps that are set for us and to control our appetite for spending.
1. Credit cards
Credit card debt is the Achilles heel of many people. The main reason is that the banks make it extraordinarily easy for you to use a credit card to buy just about anything you want. But credit card debt is unsecured debt – in other words, you do not have to provide any security for it, such as an assurance policy – and that means higher interest rates.
It is very easy to run up debt once you have a credit card in your hand, because, unlike cash, you can spend a lot more than you have.
But credit cards do have advantages. They are convenient; give you the security of not having to carry cash; and give you interest-free money for up to 55 days from the date of purchase until the repayment date (the maximum buy-and-pay cycle).
The downsides include high interest rates on unpaid debt; the ease with which a credit card can be used to impulse buy and build up debt; and the high penalty for not paying off the debt on time.
Few people know that you will pay interest at a very high rate on everything you bought from the purchase date if you have paid even one cent less than the full amount owing on your card after the due date. Many people think you are charged interest only on the unpaid portion. This is not true. You pay interest on every transaction.
Credit cards are particularly dangerous because they allow you to finance consumables, such as food and clothing, through debt. Consumables, which have no monetary value from the moment you buy them, should never be purchased on credit.
2. Store cards
An increasing number of retailers now offer store cards, and many lure you into applying for them with special offers. Retailers, like banks, realise that many people want to have their desires met immediately, so they make it easy to buy now and pay later. You would not be quite as quick to buy if you were restricted to paying cash.
As with credit cards, interest payments are high if you fail to pay on time. Many people build up a wallet full of store cards, but the more you have, the more likely it is that your mountain of debt will grow. Eventually, the total amount you have to repay every month can break your budget. Store cards should be avoided altogether.
3. Hire purchase
Hire purchase, like many other kinds of debt, is aimed at encouraging you to buy now and pay later. Hire purchase debt is aimed at financing higher-priced items, such as furniture and cars.
Again, interest rates on hire purchase contracts tend to be higher than the prime overdraft rate of interest, even though the marketing material often claims that you will pay very little in total repayments a month.
You should always add up all the amounts (capital and interest) you will pay every month until the debt is repaid, and then compare that amount with the actual price of the item. You could find yourself paying two to three times the actual cost of the item.
Remember, you are hiring the item until you have paid the full amount, so if you fail to pay, the item could be reclaimed and you could lose all the money you have paid in the interim.
Leasing has become a very popular way to finance motor vehicles. Be particularly wary when you see promises of incredibly low repayments on a motor vehicle. This is made possible by what is called residual value financing, which is structured as follows:
• You pay a monthly lease fee that is lower than a hire purchase instalment.
• You leave a large sum, called a residual or balloon payment, unpaid until the end of the contract period. The average residual value on a contract over five years is anything between 20 percent and 35 percent of the cost of the new vehicle.
• In theory, the residual payment should be equal to the re-sale value of the car. You should be able to sell the car for its residual value, pay the outstanding residual, and owe nothing when the contract expires.
As a general rule, any residual over 40 percent of the initial purchase price is too high and will result in you having to pay in more at the end of the contract than the resale value of the vehicle. A rule of thumb when deciding on the size of the residual that is appropriate for you is to expect your vehicle to depreciate by one percent a month for the duration of your contract. So, if your contract term is 60 months, your car will depreciate by 60 percent over the period. This means you should not have a residual of more than 40 percent.
To avoid ending up owing the bank more than you could get by selling the car, you could opt for a buy-back contract with a motor dealer, who guarantees to buy back your vehicle for a certain value after a set time, provided you have not clocked up more than a specified number of kilometres.
5. Easy loans
Increasingly, it is not only loan sharks, but banks and life assurance companies that offer small loans of up to about R30 000. Often the interest rate charged is not fully disclosed or is carefully hidden in the fine print. In most cases, you are lured into these loans via advertisements and direct mail that emphasise how little you have to repay each month.
If you add up the total amount you will repay – capital and interest – you will find that the total debt is a lot more than you expect. Often these loans are promoted to fund a luxury and not a need.
6. Loans from micro-lenders
The first thing you need to find out, if you plan to use a micro-lender, is whether or not the lender is lending money in terms of the Usury Act or is exempted. In terms of the Usury Act, interest is limited to 26 percent on loans of up to R10 000 and 29 percent on amounts over R10 000.
Micro-lenders who are exempt can charge what they want – and they do. They are supposed to fully disclose to you what you will have to pay, but often the facts are disguised or in the small print.
7. Variable home loans
Variable home loans can be used as a ready source of money, and more and more consumers are taking advantage of them when they have financial shortfalls. In other words, there is less of a need to be disciplined in one’s spending, because one can make use of any slack in one’s home loan.
As a consequence of this, when interest rates go sky high, as they tend to do in South Africa, many people lose their homes because they can no longer afford to pay the high interest bills.
What many people do not realise is that you may still not escape debt if you default on a homeloan and the property is repossessed. The bank will sell the property on auction and the costs of the sale will be added to the total debt. If the price realised by the bank for the property is less than the total, you are still responsible for the balance.
You will also spend a fortune in interest by maintaining a high level of homeloan debt.
Variable homeloans often do offer the lowest interest rate available, however, so they are a better option than most other types of loans.
8. Unsolicited loans
You may have been approached by an institution such as a bank, or more recently, a life assurance company, with the offer of a loan. These unsolicited loans nearly always come at interest rates close to the maximum permitted under the Usury Act.
What the institution fails to point out to you, however, is that there may be other, cheaper ways of borrowing money, such as extending your homeloan or borrowing against a life assurance policy. If you are offered an unsolicited loan, you can be almost sure it will come at a high rate of interest.
9. Hidden costs
There are a number of hidden factors in debt that push up the costs. These include:
• Administration charges. For many years banks have been hiding administration charges inside the interest they charge you for homeloans. Administration charges have become common practice with debt. You need to be absolutely sure what the administration charges are and what impact they will have on your debt. While one bank might offer you a loan at an interest rate 0.25 percent cheaper than another, administration charges can easily cancel out this difference.
• Upfront costs for registering or taking out a debt. Many institutions charge you for the privilege of being in debt to them. This applies particularly to homeloans. Always establish these costs.
• Debt settlement costs. You can be charged penalty costs for paying off a debt early. This applies particularly to hire purchase and micro-lender debt, but may apply to some homeloans too. When you have paid off a homeloan, you will also be charged a hefty sum for the legal process of cancelling the loan.
• Real interest rates. Banks and other institutions have all sorts of ways of charging you interest without you being aware of it. In most cases you are quoted what is called the nominal interest rate.
Beware: this is not as straightforward as it seems. Say the nominal rate quoted is 12 percent. The institution will split that into one percent a month – which amounts to more than 12 percent a year because you are paying interest on interest, or compound interest. You must establish the “effective” rate of interest you will be paying.
• Life assurance. In most cases the institution lending you money will require you to take out life assurance to cover your debt. This is the real money-spinner for the financial institutions, and comes close to being a racket. They pay themselves high commissions and, since they usually own the life assurance company, they take even more profit.
This is not to say that life assurance against debt is not important. It is. You do not want to saddle your dependants with debt when you die. You must, however, be careful. You are not obliged to, and you should not, take out life assurance with the institution offering you the debt unless you have first obtained quotes from a number of life assurance companies. It is often just too easy to sign on the dotted line, but your signature could cost you thousands of extra rands.
And be careful of life assurance add-ons. Many companies, particularly in the motor vehicle industry, will encourage you to take out policies for periods longer than the debt and to have an investment amount added. You do not need this, particularly if it does not fit in with a well-structured financial strategy.
Another racket still perpetrated by some institutions, particularly with homeloans, is to get you to repay only the interest on the debt, not the capital amount. The money that would have gone to repay the capital is used to pay a life assurance investment policy. The theory is that at the end of the repayment period, your investment will have made enough money to repay the debt.
The questions you need to ask are how much will you pay in interest over the period and what happens if investment markets do not do well?
To further complicate this schlenter, the policy will be escalated every year, so that, in the end, you are paying considerably more in premiums than you would have been paying in capital repayments on the loan. All the premium escalation will have done is bluff you into thinking that your investment has done extremely well. Rather repay debt as quickly as possible and then use the money to build up your investments.
10. Debt consolidators
Understand and beware of debt consolidation. There are two types: one useful and the other highly costly.
Many financial institutions now offer a one-stop debt facility to cover your homeloan, vehicle finance and whatever else, usually at an interest rate lower than the prime rate. This type of debt consolidation is not a bad thing if you go about it wisely.
What you do have to watch out for is those advertisements for debt consolidation that start out asking you if you have debt problems. The advertisers then offer to deal with your creditors and help you repay your debt.
Beware. In all likelihood your debt headaches will increase. They will speak to your creditors and they will consolidate your debt so that you have to make only one payment a month, but you will find there are a bevy of administration charges and you are paying top interest rates. In fact, so rough are the conditions that you are likely to remain in an invidious position for many years. Your better bet is to negotiate with your creditors yourself, telling them about your total debt and how you intend to repay it.
10 golden rules for credit cards
The undisciplined use of credit cards is the quickest route to crippling debt. Here are 10 rules to take control of them.
1. Always repay the full amount due. Never make the minimum repayment only. The reason is that the minimum repayment required by your bank is basically only the interest you must pay on the debt you have built up. So you will never get rid of your debt if you always only repay the minimum.
2. Never use the “budget” section of your credit card. This is definitely not a way of budgeting. It is a way of getting deeper into debt.
3. Do not regard a credit card as a status symbol. See credit cards as a potential symbol of debt.
4. Never have more than one credit card. Every card has its own credit limit and you will be tempted to use them all to the maximum.
5. Remember that credit card interest rates are punitively high.
6. Never impulse shop with a credit card. Credit cards promote impulse shopping, but this will have a very negative effect on your budget.
7. Only use your credit card to pay for things for which you have budgeted.
8. Never use a credit card for a cash advance unless you keep your credit card account in credit. You will pay interest from the moment you borrow money on your card, even if you repay the full amount owing on it by the due date. This also applies if you buy petrol on your card – it is counted as a cash withdrawal.
9. If you already have credit card debt, consider paying it off with money you can borrow elsewhere at a lower rate; and then pay off that debt too.
10. Destroy your credit card now if you find you cannot restrain your use of it. If you need a credit card for convenience or security, you can ask your bank to reduce the credit limit to zero or a low amount, such as R1 000. If your limit is zero, this will force you to keep credit balance on your card. In other words, it becomes a real credit card, not a debt card.
10 warning signs that you’re deep in debt
Here are 10 major warning signs that you are too deeply in debt:
1. You have negative net worth. In other words, you owe more than you own.
2. Your spending exceeds your income every month.
3. You have bounced a cheque in the last three months because you did not have sufficient funds in your bank account.
4. Your bank account has been closed; or you have been asked to return a credit or store card.
5. Most of your bills are two or more months in arrears.
6. You have problems juggling around who you are going to pay this month.
7. You consider unused credit facilities as part of your wealth.
8. A debt judgment has been obtained against you.
9. More than 25 percent of your income goes towards paying interest on your debt.
10. More than 40 percent of your income goes towards paying off debt.
Seven ways to get out of debt
Here is a seven-point strategy to take control of your finances and avoid debt traps:
1. Reduce unnecessary spending. This can take the form of doing little things, from taking sandwiches to work instead of eating out, to delaying the purchase of a big ticket item, such as a new motor vehicle. A motor vehicle is a major expense, particularly when financed with a loan (you have to pay interest). Often the only reason to replace your perfectly good existing vehicle is to get one with different-shaped headlights.
2. Do not borrow any more money, particularly from loan sharks, whose interest rates are prohibitive and could lock you into years of misery.
3. Speak to the people to whom you owe money, particularly your bank. Your bank will do the best it can to show you the way out of your problems. Your creditors will be more understanding if they see you have a plan to get out of debt and are prepared to make sacrifices to get there.
4. Pay off high-interest, short-term debt first, particularly credit cards. If you can switch your debt from a high-interest to a low-interest loan, do so. This could be possible if you have a long-term, secured debt such as a homeloan. However, you must increase the repayments on the lower interest loan.
5. Close accounts and tear up credit and store cards as you pay them off.
6. Do not gamble in the hope of scoring a big win. The odds of it happening are very small. The odds-on the bet of gambling is that you will lose all your money, only making your situation worse.
7. You should not be making investments while you have high debt. Always pay off debt before you start investing. There are two reasons for this:
• The interest you pay is likely to be higher than any returns you will receive on an investment; and
• If interest rates move to high levels you could be forced to sell your investments to reduce your level of debt. This may mean selling when the value of your investments is low. You should never be in a position where you are forced to sell your investments at the wrong time for the wrong price.
This article was first published in Personal Finance magazine, 1st Quarter 2003.