Debt: Why debt costs money

In Debt, Latest by Kristia van Heerden

Sometimes debt is our only hope in a difficult situation. When debt is used intentionally, it can be a wonderful resource. Sadly, there is a fine line between a healthy amount of debt and debts that are out of control. That’s because debt isn’t free. 

In this article we’re going to discuss three reasons why you always have to pay back more money than you borrowed.

Interest: two sides of the same coin

Interest is one of the five concepts you need to understand to make good financial choices. 

 

Simply put, interest is the cost associated with using someone else’s money. When you have money to lend, you earn interest. When you borrow money, you pay interest. It can be a tool or an obstacle.

Being on the right side of interest is like getting free money. You might not think much of your humble bank account, but when you save money in an interest-bearing account, the bank is putting that money to work when you don’t use it. They pay you interest for the privilege of doing so. 

Unfortunately, interest reveals its ugly side when you borrow money. The person or institution lending you money gets to charge a fee for the use their capital. In this case, interest is making your poorer. Whenever you buy something using debt, you have to add the interest to the price of the item to get to the true cost.

Have you ever wondered why so many banks tie their reward programmes to their credit card facilities? In the below example, you’re going to see how much money the bank makes when you borrow money.

Example: Credit cards and interest

Fungai and his girlfriend recently moved in together. They decided to buy a new couch for the living room using Fungai’s credit card. The couch they love costs R5,000, which they intend to pay back over two years.

Without interest, they would pay back R208.33 per month for two years. The same amount saved over the same period would let them buy the couch cash. However, Fungai’s bank charges 21% interest on his card. On the full amount outstanding, Fungai would have to pay R2,100 in addition to the R5,000 he borrowed. They could have bought a much nicer couch with R7,100. 

Luckily for Fungai, that interest is calculated monthly on the outstanding amount. If he diligently repays his R208.33 every month, the interest he has to repay will be calculated on the smaller amount he owes every month and reduce over time. If he sticks to his repayment plan, in month two he’ll only owe R4,791.67, which he’ll need to pay interest on. 

Unfortunately, credit cards make it really easy to get access to debt. After six months of diligent repayments, Fungai decides to use the R1,249.98 he’s repaid to buy his girlfriend an expensive birthday gift. That resets the amount he owes back to R5,000, which means he starts all over. 

In this situation, Fungai gets the couch he likes without having to save for two years. The bank, however, gets to make money every month simply by giving Fungai access to a credit card. Can you see why the bank is paying you loyalty points for your credit card? 

Account fees

Interest is only the beginning. Many shops and banks that lend you money charge you to have an account with them. This fee is usually paid monthly and it can seem quite small. 

For example, you may have noticed your clothing account has a fee of R48. That amount gets added to the final amount you owe, which is why it’s important to go through your statements line by line. On a monthly basis, that might not seem like much, but over a two-year period that’s an additional R1,152 out of your pocket. 

If Fungai also had to pay a monthly account fee of R48 on his credit card, his total debt would go to R8,252. Remember, if he paid cash for the couch, he would only have paid R5,000.

Collection fees

It’s no wonder we fall behind in our debt repayments! The money we borrow is only the tip of the iceberg. When we fall behind, our accounts get handed over. As we explain in this article, accounts get handed over to debt collection agencies when you fail to repay your minimums. You may not know that being handed over results in even more fees.

When a debt collector calls or emails you, R20 is added to the amount you owe. Every SMS the debt collector has to send you adds R2.80 to your outstanding debts. For this reason, it’s incredibly important to answer the phone when a debt collector calls. As we explain in this article, a debt collector can be a friend to you in a tough time by reducing your instalments and helping you formulate a repayment plan. 

Once you’ve agreed on a manageable repayment plan, make sure you stick to it so the debt collection agency doesn’t have to call to remind you. A debt collection agency is allowed to charge as much as R965 in fees. That brings Fungai’s couch to R9,217! 

How does a small loan turn into an unmanageable amount of debt? As you’ve seen in Fungai’s case, it can happen in the blink of an eye. If you decide to take on debt, spend a few minutes to work out what your debt will really cost you. There are a number of free interest calculators available online. Remember to keep a close eye on your statements, avoid high account fees and to close accounts that are no longer in use. Even if you don’t pay interest, you’ll keep paying the account fees. 

This series will help you gain control of debts that have spiralled out of control. We will explain what it means to be handed over for collection and how that differs from debt review, debt consolidation and insolvency. We will help you understand your rights as a consumer and offer some debt management strategies. This series is possible with the help of VeriCred, our partners in debt education.

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