Payday Loans: Who Is The Biggest Shark of All?Sep 8, 2015 Blog Business Finance
The other day I was waiting for a bus, and at the bus stop were two ladies having a good chat. The one lady was showing the other lady her new shoes that she was wearing. After admiring the shoes, her friend asked her how she could afford them as they looked expensive. The owner of the shoes responded that she had borrowed the money and would pay it back when she received her salary.
This is called a payday loan and it is very expensive money. There are a number of providers in South Africa offering short, little loans and there is remarkable little difference in the cost of these loans. The reason is that they all charge the maximum allowed by the National Credit Act (NCA).
Let’s use our friend with the new shoes as an example. For ease of calculation, let’s assume the shoes cost R1000 and she borrowed the money half way into the month, so she would repay the loan 15 days later.
Her total repayment at the end of the month would be R1,258.10
So our friend’s shoes cost her an extra R258.10, just so she could have them 2 weeks earlier. People get wealthy by paying less for things, not more.
Not all loans are for such frivolous things. There are many people who struggle to make ends meet and need money for very important things, like food or transport.
High Interest, Higher Fees
Let’s take the example of a family that has an income of R10,000 per month. They were managing to get by, but with the increase in food, petrol, etc, they suddenly find that they don’t have enough money for the last week of the month. So they borrow R2000 for 7 days.
Because they only need the money for 7 days, the interest charge is low (the interest rate is actually very high, around 60% per annum, but the period is short), only R26.92. But unfortunately, the interest is only a small portion of the cost of the loan, the majority goes toward the fees. In this case the fees are R342. So the loan will cost them R368.92.
This chart illustrates how much of the cost of the loan is interest vs fees:
What this means is that it doesn’t make much difference if they borrow the money for 1 day or for 30 days as most of the cost comes from the fees. To add insult to injury, they charge interest on the fees, even though the borrower is not borrowing that money.
So our family starts the new month with a debt of nearly R2,400. Which means they have to survive on the balance of their usual income which will be about R7,600. Chances are they will need to take another loan to make ends meet and this will continue month after month, a portion of their income being spent on serving the loan charges.
In a worst case scenario, as the amount they borrow increases they eventually end up in a situation where they can’t pay back the loan. Eventually they are blacklisted and life becomes even more difficult for them as they can no longer access credit.
Let’s have a closer look at the fees. The maximum that can be charged for loans up to a month, according to the NCA, is:
Initiation Fee (once off): 15% on the first R1000, then 10% on the amount above R1000, to a maximum of R1000
Service Fee (Monthly): R50 (even if the loan is for less than a month
These fees also attract VAT, so the borrower will pay a service fee of R57 plus an initiation fee which will vary depending on the amount borrowed.
Then there is the interest charge, at 60% per annum.
The following illustration shows the relative proportion of the various charges on a R2,000 loan. Bear in mind that the interest charge is also increased because the borrower is paying interest on the initiation fee and service fee too.
While the initiation fee and service fee would be negligible on a big loan such as house or car loan, when it comes to smaller loans, these fees add significantly to the cost of the loan. And when it comes to microloans, the fees dwarf the interest charges considerably, as we saw in the previous examples.
Avoiding Payday Loans
The key to avoiding payday loans is budgeting. As living expenses increase, budgets should be updated to ensure that there are funds for necessary expenses. When the household budget is not kept up to date, increased or unexpected expenses could mean that a loan is the only option.
Another important way to avoid borrowing money is to save. Many households spend all of their income and then when unexpected expenses arise they have to borrow. Make a habit of putting away a portion of the household income each month.
Alternatives to Payday Loans
Sometimes life throws us a curveball, and we have no option but to take a loan. Payday loans should be a last resort and luckily there are other options.
If a person is in good credit standing, there are options for obtaining credit from banks. This could be in the form of an overdraft facility, an unsecured loan, or simply credit card debt. While these credit facilities are still quite expensive, they are much cheaper than payday loans. And because the facility is available even when not being used, there are no recurring initiation fees.
Another option, which is new to South Africa, is peer to peer lending. Using an online platform, such as RainFin (www.rainfin.com), borrowers can connect directly with independent lenders. While there are some fees involved, they are much smaller than the initiation and service fees that are tagged onto traditional payday loans. In addition, there is the possibility of lower interest rates.
To summarise what we have shared in this article, be responsible with your finances. Keep your budget up to date and save as much as possible.
If it happens that you need to borrow money, try all the alternatives before resorting to payday loans as they are extortionate.