The dos and don’ts of personal loans and avoiding the debt trap

Personal loans can be either a valuable financial tool if used responsibly, or an eternal debt trap which can increase your financial distress.

The rising cost of living and salaries that did not keep up with inflation place many South Africans under pressure to cover additional expenses while still affording the basics.

When this happens, they turn to personal loans, credit cards and unsecured loans, and this is where the concern of a debt spiral becomes real, as well as the importance of understanding good versus bad debt, says Ayanda Ndimande, head of business development at Sanlam Retail Credit. 

The latest DebtBusters Debt Index revealed that on average, take-home pay decreased by approximately a third compared to 2016.

The full impact of several years of a lack of salary increases, inflation and multiple interest rate increases, along with increased electricity and petrol prices, are now taking their toll on consumers’ budgets.

South African consumers’ reliance on debt was also highlighted by local analytics consultancy Eighty20, that found that two-thirds of the average middle-class salary is used to pay off debt.

Ndimande says the tough economic times are also evident when considering how many clients’ applications for credit are declined due to increasing defaults reflected on their credit records at bureaus.

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Debt is inevitable

Debt is inevitable at some point for most South Africans, as few people can afford to pay cash for a house or a car.

However, being responsible with debt by paying off your credit card and making loan payments on time every month, helps to develop a good credit score and makes you a more attractive candidate when applying for a home loan or vehicle financing, Ndimande says.

You are entitled to a free credit score check every year and if your score is low, you can ask a credit management coach about ways to get back on track financially.

“Credit and personal loans in particular are not necessarily bad, but it is important to understand when and when not to use them and how much credit exposure is reasonable. For example, a personal loan could push you further into a debt spiral, but it could also help you gain economic stability.”

ALSO READ: SA women have less debt than men, but face bigger risk for over indebtedness

Responsible use

When you use a personal loan responsibly, it can add value to your life or be an investment in your future.

These are examples of ‘good’ reasons for taking out a personal loan:

• Education: funding education or furthering your studies provides more employment opportunities and increases your earning potential.
• Home renovations: this is an investment for the future, improving the resale value of your home.
• Debt consolidation: Known as a consolidation loan, this can improve your cashflow by only having one debit order and paying a lower total premium.

However, Ndimande cautions that the risk of a debt spiral escalates when taking out a personal loan to fund everyday activities, holidays, entertainment, clothing, or things that have no future value.

“Once you bought something, payment continues for months, while you see no value.”

She also warns that personal loans taken out on a month-to-month basis are especially risky.

Many people find it hard to get out of the loan spiral and end up accumulating more and more debt over time. That is why they often turn to unsecured loans or even unlicensed moneylenders out of desperation when they cannot pay instalments, exacerbating the problem.

ALSO READ: How to start getting rid of your debt

NCR guidelines

“However, authorised financial services providers offer personal loans which follow the guidelines set out by the National Credit Regulator. For example, Sanlam Personal Loans also strictly adheres to an internal credit policy that takes into consideration credit, as well as affordability assessments, to ensure responsible lending practices,” Ndimande says.

“If you realise that you can no longer manage your debt, speak to your creditors to work out a payment plan. If you have credit available, first assess your needs and work out your affordability. It can feel overwhelming to know where to start, but you do not need to go on this journey alone.”

She advises consumers to speak to a financial adviser who can support you through these big decisions and help you manage your credit responsibly while building wealth.