The National Credit Act: is the regulation of payday lending sufficient?

Zulaikha Brey and Fouche Venter

“South African consumers drowning in debt: NCR.”[i]

“South Africa: A country drowning in credit.”[ii]

“SA drowning in debt… and sinking deeper.”[iii]

These are only some of the headlines that have appeared in the media regarding household debt in South Africa. Figure 1demonstrates that, even though household indebtedness has improved since 2008, it is still worryingly high when compared to preceding years.

Figure 1: South African household debt as a percentage of disposable income

It is however important to acknowledge that not all debt is bad. People may take out loans to finance property or education, for instance, which leads to physical and human capital accumulation. Healthy borrowings, however, are not exclusively meant for investments, but can also be used for expenses provided the loan period roughly correlates with the useful lifetime of the purchased good or service (and, of course, that the borrower can afford the repayments). Unfortunately the data in Figure 1 does not take these considerations into account.

Nevertheless, many South African are likely to be caught in a spiral of uncontrolled debt. If you drive through Pretoria city centre, watch prime time television, or simply search “short-term unsecured loans” or “payday loans” on the internet, you are inundated with offers for short-term credit. These types of loans (payday or short-term unsecured loans) are regulated by the National Credit Act as short-term credit transactions. This includes loans up to R8000 where the amount is repayable within 6 months.[iv]

In practice, however, payday loans are almost always offered over a 30 to 40 day period and seldom exceed R3500. Payday loans are intended to supplement a borrower’s salary during months when unforeseen expenses are incurred. Providers actively advertise that people may qualify for a payday loan even if they have a bad credit record; and in some instances, loans are even extended to blacklisted individuals. The industry focuses on consumers who are unable to access credit through traditional financing mechanisms. This fact, coupled with the relatively small size of loans, points to payday loans typically being utilised by low income earners Studies done on the characteristics of the average payday loan user have also confirmed this tendency[v].

In addition to capping the time period and amount of payday loads, the National Credit Act also sets a maximum monthly interest rate of 5%. The interest rate may be calculated daily, but can only be added to the loan amount once a month. Additionally, a maximum service fee of R57 and an initiation fee is levied on every transaction. This initiation fee is calculated as R171 plus 10% of any loan amount exceeding R1000. The total cost of a payday loan is illustrated in the example below.

Even though the interest paid for this 30 day loan is marginal and seems reasonable (5% or R50), the total repayment amount adds up to 27.8% more than the borrowed amount. Therefore, even if you “follow the rules”, this loan is expensive. What would happen if you found yourself unable to make this payment at the end of the 30 day period?

You have two options: i) you can extend the loan, or ii) you can pay back the loan by taking out another loan from another institution. If the loan is extended, the borrower does not incur an additional initiation fee. The rational option for the borrower is therefore to extend the loan twice and then take out another loan before the borrower’s credit rating is affected. If the loan is extended, R1398.90 will be owed at the end of the second loan period (Day 60). After another extension, the amount owed ads up to R1 525.85 (Day 90). If the borrower is still unable to pay back the loan, the option of extending the loan even further would now have dissolved as lenders will be unable and unwilling to roll-over loans indefinitely. Consequently, the borrower only has one option left, which is to pay back the loan by taking another loan from another institution. He or she is able to do this because payday lenders do not perform credit checks and the second institution will subsequently be unaware of the loan their new customer has at the previous institution. Once again the borrower would pay an initiation fee and would now owe the new institution a R1882.72 after the first 30 days.

Figure 2 shows how quickly payday loans can spiral out of control for the borrower. After 6 months the borrower that borrowed a R1000 owes R2192.55, 119.3% more than originally borrowed.

Figure 2: Debt spiral

The scenario described above raises a question – why would a payday lender continue lending money to a risky customer with the inability to pay back the initial amount? As payday lenders do not perform credit checks, it is possible for a single borrower to hop from one payday lender to the next to finance the repayment of existing debts. While this may not seem like the smartest financial decision, the majority of the users of these payday loans are not financially educated and/or desperate. They thus only see the short term benefits of the next loan, while completely overlooking the long-term debt trap.

While payday lending is regulated in terms of the maximum deferred amount, the interest rates charged and service fees levied, an assessment of whether a loan is affordable to the consumer is not mandated. Given that payday loan beneficiaries are generally from low income brackets, with bad credit records, poor financial management skills, and little understanding of the long-term effects of their financing decisions, the probability of landing in a debt spiral as per the example is high.

Short term credit transactions (as defined in the NCR) avoid the more onerous regulations applicable to higher value and longer term loans in South Africa because they are seen as crucial to allow poor consumers to respond to ‘emergencies’. This situation, has led to payday loans being potentially very lucrative. By classifying the users of payday loans as high risk, lenders can justify the application of high (regulated) costs, and as such these loans are economically sound.

By adhering to the requirements of the NCR, payday loans are perfectly legal. But by enabling entry into a debt spiral as illustrated earlier, which arguably is based on exploiting the lack of understanding and ignorance of users regarding the long term effects of such loans; the ethics of the current system of payday loans are questionable.

The current system of payday loans isn’t set in stone. Several avenues exist for the tightening of such loans in a way that they still offer real benefits to a large portion of the South African society while removing some of their unintended consequences. Some regulatory options include:

i. Force lenders to conduct credit checks on consumers.

ii. Create a database for short term loans (if accessing the credit bureaux is too tedious) – by doing this, one could limit the number of payday loans a single person could take out.

iii. Make debt counselling a condition for the extensions and rollovers

iv. Educate the general public about the risk and consequences of debt spirals.

v. Remove the fine print – force lenders to remove the “legalese”, and write all terms and conditions in a language the is clear to consumers.

The cost implications of increased regulation would, however, need to be considered carefully to ensure these loans remain accessible to the users.