The trap of personal loans and credit cards

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We do not deny the fact that a loan can be used to improve your life, but this is only true if you are smart enough with your money management. Not all debt is bad. Debt can be rewarding if it is used wisely. You can use debt to finance your business or for investing. The problem is that debt is open for everyone with a good credit score even though you may be poor at managing your finances. This is the reason why the trap of personal loans and credit cards is real.

Most middle-income earners in South Africa are struggling to payoff either their credit card or personal loan. Why are personal loans and credit cards more damaging than home loans or car loans?

Both types of loans are not secured. This means the loan is not attached to any asset of the debtor (that is there is no collateral). Since there is no collateral attached to the loan, the interest rate will be high to protect the creditor from losing the money if the borrower defaults on the payments.

Home and car loans are secured loans in the sense that the house and the car, respectively belong to the creditor before the loan is fully paid. So, if a creditor fails to pay, the creditor will recover the amount owed by selling the asset that is being held as collateral.

What is a personal loan and credit card debt?

A personal loan is the money that you borrow from the creditor (for example a bank) to finance a personal need (like a wedding or a trip oversees). In return, you pay fixed payments (usually monthly payments). The payments will go towards paying interest and part of the loan.

A credit card is a card that is issued by a creditor and it allows you to borrow money up to a given limit. You can make transactions with a credit card exactly the same way you can do with your debit card. Interest is only charged on the credit card if you borrow the money and not pay it off within 30 days. There are also extra fees that are charged if you withdraw the money or transfer to another bank account. If you accumulate debt on your credit card, you are required to pay a given minimum amount every month until the whole debt is paid off.

Moreover, both the credit card and the personal loan behaves the same but a credit card is a bit difficult to pay off quickly. This is because a credit card can allow you to borrow again before paying off the full amount.

Suppose you have a credit card with a R 20 000 limit and you spend all the money. If you manage to payback R 5 000, then you have made a R 5 000 debt available for you to spend again.

If you are not disciplined, you will keep on adding money to your credit card and withdraw it thereafter without paying off the debt completely. This is the biggest trap of credit card debt.

How do the personal loans and credit cards work?

Credit Score

Before your personal loan or credit card is approved, the creditor will check your credit score. This score is a measure of your risk level, that is your ability to pay back the money you borrow.

A credit score is built by borrowing and paying off the debt. It does not matter whether you have a lot of money in your investments, a credit score will only track the debt you have acquired.

Insurance

Have you ever considered what will happen to your children when you die and leave debt behind? What if you lose your job through retrenchment? To cover for this, it is a requirement for every personal loan and credit card applicant to have insurance that covers events like death, disability and retrenchment.

Interest rate

This is the biggest trap for personal loans and credit cards. The terminology for interest rate is confusing to a lot of people. The interest will vary depending on how good your credit score is. You need to understand the term ‘compounded monthly’ . If a loan is compounded monthly, it means each month, the interest amount will accumulate to your loan amount.

Furthermore, it is important not to confuse this with the phrase ‘interest is calculated daily’. The interest for both personal loans and credit cards is calculated daily but compounded monthly.

Practical example:

Suppose that you have a R 40 000 personal loan with the following terms:

• Initiation cost R 1 207.5
• interest rate is 27.5% compounded monthly
• Service cost R 69
• Insurance R 185.43
• payment term 3 years
• Loan initiation date 26 August 2019

The daily interest from the 26th of August to 31st of August will be R 31.05 (that is (27.5%/365) x (R 40 000+ R 1 207.5)) but the total interest of R 186.29 will be added to the loan amount on the 1st of September. The service cost and the insurance premium will also add to the loan amount. In this case, the service costs for August are R 13.35 (that is (R 69 /31) x 6). Therefore, the new loan balance for September will be R 41 592.57 (that is R 40 000+ R 1 207.5 + R 13.35 + R 185.43 + R 186.29). The daily interest for the month of September will be R 31.34 (that is (27.5%/365) x R 41 592.57).

This is slightly different from the way the interest is calculated for home and car loans. For those loans interest is calculated monthly and if you pay an extra amount on the loan, the loan will be restructured.

With both a credit card and personal loan, if you pay an extra amount, it will reduce the balance and therefore reduce the daily interest rate. Therefore, you do not need to call the creditor to restructure your personal loan or credit card when you make an additional payment.

How to be free from the trap of personal loans and credit cards

Making additional payments

The easier way that you can use to be free from the trap of personal loans and credit cards is to pay off the debt early. You can do that by making an additional payment. This extra amount will reduce the repayment period and also the total interest you will pay on the debt.

You can read our post about investing before paying off debt for more explanation about this.

Taking advantage of daily interest rates

If you have bills that do not require to be paid urgently every month, you can transfer the money to the credit card first to reduce the amount of interest. When the bills are due, you can pay the bills with the credit card.

Assuming your pay day is on the 25th of every month and the deadline for your rent payment is the 2nd of each month, then you can reduce 1 week worth of interest by transferring the rent money into a credit card. Please note that before you follow this procedure, understand the costs associated with transferring the money to and from the credit card.

In a nutshell, it is possible to survive the trap of personal loans and credit cards if you understand how they work. Both debts have a potential to damage your personal finances. Therefore, it is very important to understand the impact a personal loan or credit card will do on your budget before applying for one. Debt is not free money!