Tim Barnett, from FinCap, explains why you should avoid high-cost debt.

What is high-cost debt?

High-cost debt usually refers to loans that are high-interest. The shorter the loan period, usually the higher the interest rate – sometimes 700 per cent or more.

Most common are payday loans, intended to be repaid within a few weeks. These might seem useful as a short-term solution to cover emergencies. But their convenience hides the fact that they can be a potentially disastrous way to meet basic household costs.

Another type of high-cost debt is a ‘medium-term unsecured loan’, that you’re intended to repay within between two months and one year. These loans can have interest rates of 100 per cent or more.

Why you should avoid high-cost debt

Over time, high-cost debt is likely to drag you down. And once you’ve taken on debt, it’s really easy to get caught in a debt cycle.

Loan companies make big profits. The profit comes not just from the loan interest and associated fees, but also ‘default’ payments customers end up paying when they fall behind.

The loans look attractive. They’re often advertised with soft or amusing images in prime-time television slots. The money seems easier and faster to access than bank loans.

Usually there are promises of “approved in one day” or “get money immediately”. But many people overlook how serious this type of debt is.

The sting in the tail, as well as the high interest costs, is what can happen when you miss a payment, when the lender adds default payments.

The only reason you should consider this type of loan is if there’s no other money available, you need the money immediately and you have a secure way of paying it off each week comfortably without defaulting.

It can also affect your credit rating

It’s common with high-cost debt to find yourself trapped in a cycle of being unable to stay on top of repayments.

That’s because unexpected things happen in life and, despite your best intentions to meet your repayments, other urgent things might come up. It’s a tough cycle to get out of.

Getting into trouble with repayments can also have a long-term and bad impact on your credit rating.

You can improve your rating over time by avoiding further default on debt, but a low rating will make it harder to get more affordable loans from companies such as banks.

If you’re putting in a tenancy application to live in a rental property, a negative credit rating might affect you here too.

High-cost loans will financially hold you back as you try to clear them. All that interest will be piling up while you’re trying to build a strong financial future. It’s a tough ask.

What can you do instead, when you need cash?

· Family and friends. Never ignore the option of borrowing from family or friends. Always offer to put the loan in writing – so it’s on the record in case something happens to either of you. Be prepared to pay some interest – it’s likely to be much better value than anything available on the market.

· Consider ‘microfinance’. There’s a limited range of microcredit (microfinance) products available. They include a Step-Up loan, which is funded through the BNZ and available for people who qualify for a Community Services Card. You can borrow $1000 to $5000. The interest rate is 6.99 per cent a year, and you have three years to repay the sum. That would mean, for example, $36.75 a week repayment for three years.

· Get a loan from a reputable company. The third option (your credit score allowing) is to look at a more affordable, unsecured loan product from a reputable company – aiming for a longer repayment period. Current online information on products shows repayment periods of six months to seven years, and interest rates of 12 per cent to 36 per cent.

· Withdraw your KiwiSaver money. If you’re in real strife, the fourth option is to seek a hardship withdrawal from your KiwiSaver provider. That’s a big step to take, since you’re directly eating into your life savings. Your KiwiSaver provider handles the application, and then it has to be approved at a second stage. This can sometimes be difficult to get – you need to be able to prove you’re already in dire straits (missing rent or mortgage payments) and you can’t withdraw it just in case.

First published 31 October 2018

Story by Tim Barnett. Tim is the chief executive of FinCap. FinCap offers support to all budgeting and financial capability services in New Zealand. It provides budgeting services with all the resources they need to help clients safely and confidentially.