From payday loans to credit cards: what are the debt traps?

If you find yourself in a financial bind, it’s good to know that there are options to help you out. However, it’s really important to enter any financial contract with your eyes wide open. Otherwise, you run the risk of facing some serious financial trouble, particularly in the case of payday loans. Canstar explores what types of loans are available in New Zealand, as well as what you need to look out for.

What is a payday loan and what do you have to watch out for?

A payday loan is a small, short-term unsecured loan. The repayments usually coincide with the borrower’s payday, hence the name. Payday loans are characterised by high rates of interest and, generally, a small dollar value.

Payday loans should not be used as a long-term strategy to get out of debt. The cost of the loan is usually much higher than other forms of lending. Don’t let the lender’s catchy jingles and slick advertisements fool you. Taking out a payday loan is not a decision to be made lightly.

Currently, payday lenders are able to charge 2% interest per day on defaulted repayments (when you miss a repayment date). That means that over the space of a year, a $600 debt can blow out to $4,980 if you fail to make any payments.

Acknowledging the severe financial penalties associated with these types of loans and how quickly they can spiral out of the control of financially vulnerable borrowers, the government is enforcing new consumer-protection laws. New regulations – that will be brought in as part of the Credit Contracts Legislation Amendment Bill – include: a credit cap, so that borrowers won’t pay more than double their loan (including interest and fees), a rate cap of no more than 0.8% per day in interest and fees, and new requirements for lenders to ensure borrowers can repay the loan.

All lenders offering consumer finance will also be required to undergo “fit and proper person” checks before they are allowed to operate. To give lenders time to adjust to these changes, the legislation will be phased in, with some provisions applying in June, and taking full effect from April 2021.

If you’re considering a payday loan, regardless of whether the government’s new consumer protection laws have kicked in yet, read any terms and conditions extremely carefully, including about any potential penalties (default payments) if you miss a repayment.

Secured loans vs. Unsecured loans

 

Secured loans use an asset to secure the loan, such as a car. This asset is then used as security against the debt. Unsecured loans are when the lender doesn’t use an asset to secure the loan, but the loan is still subject to your ability to repay it. Interest rates on unsecured loans are usually much higher than secured loans, to reflect the higher risk for the lender.

 

What is an overdraft facility and what do you have to watch out for?

An overdraft facility is an arrangement between a lender and a customer, based on the customer’s credit rating and their ability to pay back the money. Usually, a personal overdraft may be approved for an amount of around $500. This facility allows a customer to overdraw their account at an interest rate similar to that charged on a typical personal loan. An overdraft facility can be either secured or unsecured.

This product tends to be a short-term, small credit facility. It’s not a tool to be used for debt management, but will help a consumer who occasionally needs to meet sudden bills or fees.

If you’ve another type of product with a provider, such as a home loan, then you may be able to get a lower interest rate on an overdraft.

Be aware that some transaction accounts allow you to go into an “unauthorised account overdraft”, where payments are processed that puts your account into the red. For example, when an automatic payment for a utility bill is processed when you don’t have enough money in your account. Interest rates for this type of unauthorised overdraft can be much higher than for an approved one. Some utility providers will let you sync your bill payments with the day your pay goes into your bank account, so that could be one way around the risk of falling into an unauthorised overdraft.

What is a credit card and what do you have to watch out for?

Credit cards are a form of revolving credit. They provide a fixed limit that can be drawn down and repaid according to the borrower’s requirements and offer convenient interest-free periods. Because they are a form of unsecured debt, their interest rates tend to be higher, over 20%, but provided you pay off your balance in full each month, they’re a great tool to help you manage your expenses.

There are a couple of key things to watch out for with credit cards:

Yes, they can be a fantastic tool for helping to manage spending and even to earn reward points. But if you don’t meet your repayment dates, then you’re going to get stung with interest. And the longer you leave it, the more interest you’ll have to pay.

Also be aware that if you use your card to make a cash advance, you’re likely to pay an extra fee and a higher interest rate on the money you’ve withdrawn.

Just to reiterate, Canstar isn’t here to tell you whether or not you should get a credit card, that’s a personal decision. What we can do is help you understand the benefits and risks, and show you which options are available.

Canstar compares different credit card types, depending on whether you are looking for a lower rate, lower annual fee or ability to earn rewards. Just make sure you are balancing rates and fees against features. To compare credit cards, just hit the button, below.

Compare credit cards with Canstar

What is a personal loan and what do you have to watch out for?

A personal loan is a larger credit facility (up to $100,000) that can be taken for a longer term, generally a maximum of 10 years. It can be a secured or unsecured loan.

You can use a personal loan to buy big-ticket items, such as a car or boat, or as a way to consolidate multiple debts into a single loan. Because it’s a fixed sum over a fixed term, you know exactly what your repayments are.

Even so, there are a few things to watch out for with personal loans. Check whether you’re allowed to make additional lump-sum payments without receiving early repayment penalties. That way, if you come into some money, such as a work bonus, you can use it to pay down your debt. Also, make sure you check for any attached fees before you sign up, such as application or ongoing fees, as well as any penalties for late payments. Factor any fees into the cost of the loan.

Compare personal loans with Canstar

What is a home loan redraw and what do you have to watch out for?

A home loan redraw facility allows you to borrow against the equity you have in your house via mortgage repayments. A common reason for this type of loan is property renovations. This can be a much simpler, and cheaper, method of financing such projects. Be mindful, though, that if you don’t pay extra money to cover the redraw amount, you’re effectively lengthening the life of your loan. Shop around to see what suits you best when it comes to home loans and home loan providers.

Compare home loans with Canstar

Whatever type of loan you choose, be honest with yourself about the size of the debt you take on and your ability to repay it. This will put you in a much better position to choose the type of loan that will best suit your financial needs.

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