A loan is a concept that most people are familiar with. Merriam Webster defines a loan as money lent at interest to pay for something. The definition goes on to say that it is temporary and is meant to be paid back. However, how well are you informed about its inner workings?
As Sir Francis Bacon said, “Knowledge is power”, and being in the know - especially when it comes to your finances - empowers you to make better financial decisions.
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Justmoney explores the “fine print” of loans in this easy-to-understand guide.
Getting down basics
A loan is usually made from a bank or a formal financial institution both in the event of expected and unexpected instances and follows a secured or unsecured structure. Understanding the difference is often the trick to ensure you make the right choice.
What are the differences?
Secured loan: This loan type refers to a big sum of money that is borrowed with the intent to purchase a big asset such as a home or a vehicle. This asset then acts as collateral for the loan, meaning that should you default on payments the asset stands as surety and may be repossessed.
Other examples of these loans include bond agreements, boat loans, and secured credit cards.
Unsecured loan: This loan type is categorised by a smaller sum of money borrowed. It is usually in the form of a personal loan with the intent to pay for things like student fees, holiday trips or a wedding. This loan is not collateral based.
Other examples of these loans include credit cards, travel loans, and store accounts.
Loan payments
Loan repayments should also be considered. Apart from agreeing to pay back the money in structured instalments over an agreed period, there is an interest rate to consider. This is usually a percentage-based amount that the provider adds on to the instalment and this covers the provider’s cost of lending you the money.
Interest rates are calculated from the principal amount owed. The more you borrow the higher your interest rate may be. But the borrowed amount isn’t the only thing that affects your interest rate - your credit score has a bearing too.
If you have a lower credit score you are more of a risk and may receive a higher interest rate. This means that the loan will be more expensive. However, if you have a good credit score you are likely to receive a lower interest rate and benefit from lower monthly instalments.
It is important that you request a breakdown of the fees of your loan such as early repayment penalties, origination fees, and credit life insurance etc., to ensure you fully understand what you are liable to pay.
Qualifying for a loan
For many loan applicants this tends to be the focus, but the success rate of your application starts long before the actual process.
As in the case of the loan payment structure there are certain variables and factors that determine whether you will be approved.
These factors include:
Credit score: This is a rating that indicates your risk as a borrower. It also acts as a guide that providers use to determine whether they should grant you the credit or loan and at which amount. Your score is informed by how much credit you have and how well you manage it.
Should you hardly make payments on your existing loan and fail to contact your providers to institute an agreement your score will likely be low, and you could be denied the loan.
Affordability: Here providers will use a test that is informed by your income and expenses to see whether you can afford the repayments. For this reason, one of the first questions you will be asked at application stage is whether you are permanently employed and to produce a payslip. It is possible for contract workers to also secure loans, but this is dependent on the provider and loan amount. For the provider this information is important to know whether you are receiving a stable income and if that income allows for you to cover the cost of the loan.
Another way of determining this is through your debt-to-income ratio (DTI). This percentage-based calculation looks at the amount of debt you have versus the amount of money you make to determine if you can afford more credit or are overindebted.
Before applying for a loan, it is important to understand what is required of you and how you can ensure approval.
According to loan experts the best advice is to manage your debt well. From ensuring your payments are made on time to being realistic about what you can and can’t afford. Building and maintaining a good credit score is key.
While the above speaks to all loan types, secured and unsecured, there are specific requirements that are coupled with certain loan products.
Here is a breakdown:
Understanding home loans
For most people having thousands sometimes millions of rands at their disposal to buy a home is not a reality, which is where financing comes in.
A home loan or financing option signals a large sum of money borrowed towards acquiring property. It is considered a secured loan and is based on your property or home standing as collateral or surety. This is way providers ensure they are protected. Should you be unable to make payment over a certain period your home may be repossessed.
However, before you reach application stage, remember that a deposit will be of great benefit to you. A deposit refers to the sum of money that you pay towards your purchase which lessens the amount you have left to pay on the home and subsequently your interest rate and instalments.
The next step in the process is securing the best interest rate. Often applicants are more concerned with which loan offers them the most money as opposed to which offers them the best interest rate. When it comes to a home loan, experts advise that you shop around and try and secure the best possible interest offering. This has a direct bearing on your instalments and the overall cost of your loan.
In South Africa the loan term is typically between 20 – 30 years. While applicants may be tempted to opt for a longer term than necessary to minimise monthly instalments, they may end up paying more in interest in the long run. Rather choose what is manageable but be careful to prioritise monthly cash flow over overall price.
When it comes to interest there are two options: fixed term interest and variable interest.
Fixed rate interest: This outlines a loan where the interest remains the same throughout the loan period. While this helps to better prepare financially for payments as you’re assured of a certain fixed amount, it also means you miss out on potential interest rate reductions.
Variable interest rate: Through this option you are choosing to not fix your interest. This means that depending on the current interest cycle or trend you may find yourself paying varying amounts.
The attraction here is that the initial interest on this option tend to be lower than its fixed rate counterpart. But should South Africa experience a downgrade or go through a technical recession you may find yourself paying substantially more.
A home loan is a big financial commitment and not one to be taken lightly.
Summary
- Shop around as much as you can to ensure you are receiving the best interest rate from the onset. Here you could make use of a bond originator to find and compare the best offerings.
- Saving for a deposit is worth it. This will enable you to negotiate for even lower interest rates and will shave thousands off your principal debt.
- Where possible pay extra on your repayments. While this may not reduce interest rate it will reduce your core debt and enable you to pay it off sooner.
- Be careful of extending your bond term. While it will make payments more affordable, it does mean you’ll end up paying longer and more.
To get a better understanding of home loans, click here.
Navigating vehicle loans
Like in the case of a home, a vehicle is an expensive asset. The average South African consumer simply can not afford to purchase one out of pocket. For this reason, people resort to vehicle financing or a vehicle loan.
This entails going to a bank or another formal financial institution and applying for a loan. While this process isn’t terribly complicated knowing how to get the best offer for your pocket is key.
A vehicle loan is a secured loan that is based on collateral. The collateral in this instance being the vehicle.
As in the case of securing any other loan product, your credit score, affordability assessment and payment history are important in the provider’s decision-making process.
When it comes to a vehicle loan the important variables also include the loan term, the interest, the deposit and the potential balloon or residual payment.
Here is a breakdown:
Loan term: When it comes to the loan term this is significantly lower than that of a home loan as it typically spans between three, five and seven years.
This is often dependent on the cost of the car, your financial capacity and the loan provider. The significance of a longer loan term lies in its allowance for you to pay smaller and more manageable instalments.
Interest rate: When taking out a loan and comparing offerings this becomes the most important consideration. This because a higher interest rate means bigger repayments and vice versa.
As in the case of a home loan you have the option of fixing your interest rate or opting for variable interest. While a fixed interest rate may present as higher initially, the variable option which is linked to the repo rate is subject to fluctuation.
Deposit: You may not be compelled to pay a deposit, but it can shave thousands off your principal amount and essentially mean you’ll pay less in repayments.
It is best to check with your intended provider before application stage to ensure what its requirements are around deposit payments.
Balloon payment: This outlines the payment that is due at the end of your loan term and is common in contracts where the borrower does not pay a deposit. The amount is based on the cost of the vehicle and is usually the biggest payment owed.
While opting for this loan structure means smaller repayments over the course of the contract, unless you’ve financially prepared for the balloon payment you will land yourself in financial trouble.
This is often when people opt for further financing which may mean a higher interest rate and further payments.
Another consideration is car insurance. Often providers won’t grant you the vehicle loan if the car isn’t insured as soon as it leaves the showroom floor. This ensures that the provider is covered should anything happen while you are still paying the vehicle off.
Buying a vehicle is an important decision but because it is a depreciating asset it is one you should make wisely.
Summary
- Take note of the loan term as this indicates how long you’ll be bound to the contract and essentially make payments for.
- Longer terms typically mean smaller spaced out payments whereas shorter terms indicate more expensive monthly instalments. However, this is dependent on the cost of the vehicle.
- Putting down a deposit when securing a vehicle loan is always advisable. This will save you money in the long term as you’ll end up paying lower monthly instalments.
- Do your research around balloon payments in understanding if this is the best option for you and your pocket. It may seem attractive as it allows for lower instalments initially but be wary of the residual payment at the end.
If this is the option you choose, ensure you do the necessary to save for the final payment.
To get a better understanding of vehicle loans, click here.
The ins and outs of personal loans
This is one of the most common loans issued as the barrier to entry is lower than that of secured loans. While banks offer this loan type there are increasingly more formal financial institutions that are catering to this service too.
Personal loans are typically meant for smaller purchases such as a holiday trip, home renovations or emergency medical expenses. These loans are not collateral based, so they are a higher risk for the provider to carry.
This translates into higher interest rates and shorter loan terms, making personal loans expensive.
The loan term for personal loans vary between one and five years dependent on the amount borrowed and the provider.
Because of the higher risk associated with this loan type your credit score, affordability assessment, and payment history play a more significant role. The provider needs to be convinced that you can comfortably make payments even without the threat of an asset being repossessed.
However, if you’re unable to make payments providers may take you to court and sue you for the monies owed.
Personal loans enjoy a fixed interest rate, but this is usually quite expensive as the provider needs to recover the cost of the loan in a shorter time period. To counter this expense the key is to shop around as much as you can but to do so within the same time period.
The reason for this is that providers access your credit score each time an application is made, and this is all recorded on your record. If your credit record depicts many inquiries it deters loan providers as it indicates that you’re often in need of a loan and may be mismanaging your money. It could also be indicative of someone who is overindebted.
But you can lessen the amount of inquiries or hits on your credit record if you limit the shopping around to a specified period or are pre-approved. Getting pre-approval for a loan doesn’t reflect on your credit report and so doesn’t negatively affect your score.
Personal loans are not a death sentence to your credit record. Instead the responsibility is on you to ensure you maintain a healthy payment relationship.
Should you slip up on payments the penalties on personal loans are often harsh and can put you further out of pocket.
When it comes to applying for and maintaining a personal loan the trick is to find the best deal for your pocket. Personal loans should also only be taken out if the need is urgent. If it is something that you are planning towards, saving would be the better alternative.
Summary
- Be realistic about your finances and ensure that you can afford repayments before entering into an agreement or contract.
- When shopping around and comparing loan offerings make sure it is within a specified time period to minimise the impact on your credit score.
- Maintain a good payment record to avoid notoriously expensive penalty fees.
To get a better understanding of personal loans, click here.
The low down on student loans
Student loans and financing is a very contentious issue in South Africa. Industry experts estimate that 1 in every 3 young South Africans have student-loan debt upwards of R200 000.
One of the biggest challenges when it comes to this loan product is the misinformation and lack of understanding of the process.
A student loan is a secured loan product that falls under personal loans and requires a parent to stand as surety and pay monthly interest while the student is studying. The principal debt is ultimately paid by the student once he or she has graduated and started earning.
This means that the interest rate is dependent on the credit record, affordability assessment and payment history of whoever stands as surety.
While students are expected to start paying upon graduating, certain providers allow for room to negotiate payment grace periods. This allows for the student to be exempt from making payments if he or she is undergoing an internship for example.
Providers are mindful of the weight of student debt on young graduates and the loan amount and interest are granted on an individual basis as opposed to being industry regulated.
It pays to shop around for the best offering. Certain student loan products also include benefits towards your accommodation, textbooks and other amenities.
Student loans are also largely informed by your academic results and a loan is only renewed annually if you pass the year.
Student loans are flexible in structure and the interest rates offered are on the lower end of the spectrum. Interest rates are also typically fixed which protects both the surety and the student.
The key to navigating a student loan lies in financial preparation. Not only is finding the best offer key but ensuring that you do not take on unnecessary credit is important. Though the student is not actively paying the loan while studying, being aware of all the costs involved and the repayments once he or she has a degree, will help him or her to be better prepared.
As a young South African who may not have experience in loan agreements it is advised that you read the fine print, enlisted trusted financial advice, involve a financially stable surety and make repayments a priority.
Summary
- Do the research and find a provider and an offering that caters to your individual needs. Do not be afraid to ask questions and ensure that you are aware of all the hidden costs and are comfortable with the repayments.
-Choose a surety that is guaranteed to be able to make the monthly interest payments. This will take the financial strain from you while you are still studying and will ensure that when you start picking up payments the contract is in good standing.
To get a better understanding of student loans, click here.