Money: Drawing a bead on loans

By MARK FRYER

Most times when we go shopping we know what we're getting for our money.

Shopping for a loan is different; while we hunt for the lowest interest rate, it isn't always easy to know what else to look for, or to compare the competing deals.

The rules governing borrowing, and the information consumers get, are in for change, with the Government planning to reform the law surrounding consumer credit.

The Ministry of Consumer Affairs has been working towards that goal for the past two years or so, and is due to send its findings to the cabinet in June.

Given that this is a notoriously complex area of the law, and one which has not seen major reform for the past 20 years, any change is unlikely to take place overnight.

But without waiting for the politicians, the mass of consultation documents already put out by the ministry contain some valuable lessons for anyone who goes shopping for a loan - whether it's a mortgage or a hire-purchase deal on a new washing machine.

Lesson 1: Flat rates are bad news


When is an interest rate of 15 per cent not 15 per cent?

When it's a flat rate, that's when.

We're not talking "flat" as a synonym for "fixed" here - as in a flat-rate mortgage.

What we're talking about is the flat-rate method of charging interest, an old-fashioned approach which most lenders no longer use.

However, some do, especially small cash lenders, and often quote the flat rate on the credit contract, says the ministry.

If you assume that's the same as any other other interest rate, you're in for a rude shock.

To see why, look what happens if you borrow $1000 at a flat rate of 15 per cent for a year, with monthly payments.

The calculation is simple - $1000 times 15 per cent equals $150, add that to the $1000 you're borrowing and you have $1150 to repay. Divide that by 12 and the payments are $95.83 a month.

But hang on a minute. While you're borrowing $1000, you don't owe $1000 for the full year. At the start of the year you do, but by the end of the year you don't owe anything.

To put it another way, on average, over the whole year, the amount outstanding is only $500.

Nevertheless, you're paying interest on the $1000 originally borrowed.

The actual interest rate you're paying is closer to 30 per cent than 15 per cent.

The more modern - and much more common - "accrued interest" method of charging is fairer, because the interest is calculated only on the amount outstanding, not the amount you originally borrowed.

One option for reform would be to force lenders to calculate payments in such a way that flat rates would become redundant.

Until then, they're a trap to avoid.

Lesson 2: Compare all the costs of borrowing


Quickly now, what's cheaper: a 7.8 per cent mortgage with a $500 application fee and a valuation charge, or one at 8 per cent with no up-front fees?

That's the sort of question anyone hunting for any type of loan is likely to encounter - and one that almost none of us is equipped to answer.

Wouldn't it be nice if all the costs of borrowing were rolled up into one single figure so we could go comparison-shopping for the cheapest deal?

In theory they are.

For many types of loans the lender has to spell out the "total cost of credit" - which includes the interest payments and most other charges such as booking or application fees.

Lenders also have to give the "finance rate," which is the same thing expressed as an annual percentage rate.

The idea is to make it easy to go loan-shopping but, before you rush out and ask lenders for their finance rates, there are a few problems.

Those numbers aren't required for some types of loans, such as revolving credit mortgages.

When they are required, not all charges have to be included.

For example, legal fees and valuation charges are left out when calculating the finance rate on mortgages.

And when you do get told the finance rate, it's typically just after you've signed up for a loan, or are about to do so.

So the finance rate is a complete waste of time?

Not entirely.

For one thing it can act as a red flag - if the finance rate is much higher than the interest rate you think you're paying, it might be time to ask a few questions.

If you aren't happy, after the lender has disclosed the finance rate you have a cooling off period of three working days, within which you can cancel the loan contract.

The finance rate can also be a simple way of comparing the cost of different loans - but only if they are of the same amount and for the same duration, and you bear in mind any extra charges that may not have been included.

While there are various suggestions for reform, the short-term lesson is to look at all the costs of borrowing, not just the interest rate.

Lesson 3: Getting out of debt can be costly



While cutting debt is one of the most-quoted commandments of money management, getting out of the red can come at a cost.

Lenders aren't legally required to detail the effects of early repayment, so that cost can be an unpleasant surprise.

As well as administration charges, lenders may also want compensation for their other costs.

Fixed-rate mortgages are the best-known example; if you want to get out early at a time when interest rates are lower than you are paying, the lender will want compensation for the fact that they have to re-lend that money at a lower rate.

But at least mortgage documents tend to spell out those charges - even if their size often comes as a shock.

With hire-purchase contracts, early repayment costs are harder to see.

For one thing, the law says you are entitled to get back only 90 per cent of the interest yet to be paid.

Effectively, the other 10 per cent is built into the final payment to the lender.

As well, in calculating the size of that final payment, some hire purchase lenders use something called the "rule of 78." This tends to understate the amount already paid - meaning you have to pay more to get out of the deal than you would if a more accurate method was used.

Lenders in some countries have been banned from using that approach, and that is an option here.

Until then, about all borrowers can do is try to clarify early repayment costs before signing on the dotted line.

Lesson 4: Just because the lender says "yes" doesn't mean you should


While most of us cope with repaying our debts - however grumpily - some people get in too deep, either because they borrowed more than they could ever hope to handle, because they got sick or lost their job, or because they acted as guarantor for someone else.

Is it the lender's job to make sure those things don't happen?

In a word, no.

As the law stands, lenders are not obliged to go through any sort of budgeting exercise to make sure you can pay.

That is one option for reform; the Consumers Institute has suggested that all cash-loan companies should have to provide written proof that they have worked out a budget with borrowers.

Other options might be to allow loan contracts to be changed in cases of hardship or where lenders fail to ensure borrowers have the ability to repay.

But whatever ultimately happens, for now the decision on what you can afford to borrow is squarely in your hands.

Agreeing to be guarantor for someone else's loan can also be perilous.

Many guarantors, says the ministry, have no understanding of what they have agreed to, and never expect to have to make good on their guarantee.

Again, it's not the lender's job to open their eyes, although the law does now require lenders to inform guarantors of the cost of credit.

Lesson 5: Watch out for insurance extras


Many loans come with an insurance contract attached. Mortgage lenders may require you to take out life insurance, and hire purchase often comes with credit contract insurance, often labelled "loan protection insurance" or "loan repayment insurance."

Lenders have the right to require that insurance and are not obliged to inform you of the terms of credit-related insurance policies.

The ministry says there is a widespread belief that credit contract insurance is overpriced.

What can you do? In some cases not a lot. While you can seek out the best deals on life insurance, for example, it is next to impossible to shop around for credit contract insurance.

However, you can at least make sure you aren't sold insurance that is inappropriate - one ministry briefing paper cites the example of an unemployed man who was sold redundancy insurance when taking out a loan - or insurance that duplicates cover you already have.

* Contact Personal Finance Editor Mark Fryer at: Business Herald, PO Box 32, Auckland. Phone: (09) 373-6400 ext 8833. Fax: (09) 373-6423. e-mail: mark_fryer@herald.co.nz.