Why short-term loans could cost you your dream home

Frequent short-term borrowing could be a black mark against you when applying for a home loan.
“The number of short-term loans you burn through may warn banks or other lenders that you’re having trouble managing your finances,” says Renier Kriek, Managing Director at disruptive home finance business, Sentinel Homes.

That can make them reluctant to fund your dream of owning your own property.

Easy debt
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 refuse to live without.

It’s tantalisingly easy to get hooked as well - 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.

The hidden costs
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% per month, which is around 6 times the current prime rate. “So, the more you borrow, the worse off you become financially and the more likely you are to default,” says Kriek.

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 behaviour.

Even if you’re not a repeat offender, firms offering debt counselling will often assure you that your debts will be forgiven, the slate is wiped clean and all will be forgiven. “In the real world, lenders could deny your home loan application simply because you needed debt review in the first place,” says Kriek.

Alarm bells
Short-term or unsecured loans are not an evil to be avoided entirely. They’re actually good for the economy when used responsibly.

However, 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 that is something a home loan provider does not want to make a long-term investment in,” says Kriek. “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 is a useful proxy in that regard.”

Good debt
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 an emergency 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 favorably 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,” says Kriek.

Long-term planning
Eventually, most people end up before a home loan provider in the hope of buying a house they love. 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? The lender’s modern analytical systems - often powered now by artificial intelligence - evolved to answer questions like these and exist to protect their owner from risk.

“Short-term loans that literally fund your lifestyle can easily sway the algorithm against you,” says Kriek, “especially if you are funding luxuries or nice-to-haves from easy debt rather than developing the discipline of saving.”
 
ENDS