Short-term or unsecured loans are not an evil to be avoided entirely. They can be good for consumers and the economy — when used responsibly.
Frequent short-term borrowing could be a black mark against you when applying for a home loan.
This is because the number of short-term loans you burn through could warn banks or other lenders that you’re having trouble managing your finances. That can make them reluctant to fund your dream of owning your own property.
While all debt should be managed responsibly to maintain a good credit score, for many South Africans, short-term loans are becoming an addictive way to make ends meet — or to fund luxuries they can’t afford but won’t live without.
It’s easy to get hooked — you don’t need to put up collateral to get one and you don’t have to explain what you’ll use the money for. Also, some like to think that, if they fall behind on their repayments, they can simply submit themselves to a debt review.
Introduced by the National Credit Act, a debt review is a legal process for someone who is over-indebted to settle with their creditors by paying what they can afford. A registered debt counsellor will review their finances and help them create a repayment plan.
Unfortunately, there’s no such thing as a free lunch. Short-term loans can carry much higher interest rates than other types of debt — up to 5% a month, which is about six times the current prime rate. So, the more you borrow, the worse off you become financially and the more likely you are to default.
That debt review “solution” you are being offered isn’t necessarily a safe bet either, because it will cut you off from any further credit provision for as long as it takes to remedy your past bad debt behaviour.
Even if you’re not a repeat offender, some unscrupulous firms offering debt counselling market their services by assuring you that your debts will be pardoned, the slate wiped clean and all will be forgiven. But, in the real world, lenders could deny your home loan application, or increase the interest rate offered, simply because you needed debt review in the first place.
Short-term or unsecured loans are not an evil to be avoided entirely. They can be good for consumers and the economy — when used responsibly.
But they’re also a red flag to home loan providers when they feature strongly in your financial history, even if you’re keeping up with repayments.
Credit providers use various risk models to identify patterns in our spending behaviour — good and bad. They know what financially responsible and irresponsible spending patterns look like.
Frequent short-term loans — with or without defaulting — are a risky pattern that implies an individual does not manage debt well, and cannot delay gratification, and that is a pattern home loan providers want to avoid investing in long-term.
The ability to delay gratification is the underlying attribute that responsible users of credit have but there is no easy way to quantify whether a particular applicant possesses that trait. The number, frequency and type of unsecured credit transactions they make is a useful proxy in that regard.
So, what is the right course of action, especially if you already have short-term loans?
First, understand that short-term loans have their place but are seldom necessary. Stop using them and make a plan to pay off the ones you already have. Then get to work on building a fund of cash that can only be touched for true emergencies, so that you will not need unsecured debt in those cases.
Second, work on saving for luxuries such as holidays and large capital purchases. You will be paying monthly anyway, whether you take the credit or save, but in the saving scenario interest will be working in your favour rather than against you. Delaying the gratification of that large purchase is difficult, but no one said adulting would be easy.
Finally, if there is no other option, opt for “good” debt as far as possible. Buy your clothes, furniture, appliances, groceries and other items using store credit if you absolutely cannot do without. You don’t have to buy things you don’t need to build a good credit score. Everyday items and normal household purchases are fine.
Credit providers’ risk algorithms generally look favourably on consumers who start their credit journey with store debt because it fits the pattern of responsible spending, provided you pay your accounts on time, of course, and do not spend near or above your credit limit. Aim to stay below 60% of your available credit limits.
Eventually, most people end up before a home loan provider in the hope of buying a house. But lenders are profit-makers and risk reducers, so it’s important to think like they do.
Are you a good investment? Will you repay your home loan on time and in full, even in times of market stress or downturn? The lenders’ modern analytical systems — often powered by artificial intelligence — evolved to answer questions like these and exist to protect their owners from risk.
Short-term loans that literally fund your lifestyle can easily sway the algorithm against you, especially if you are funding luxuries or nice-to-haves from easy debt, rather than developing the discipline of saving.
Renier Kriek is the managing director of home loan provider, Sentinel Homes.