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How loans work
How loans work
Staff writer
Posted 03/12/2021 Updated 17/02/2023 5 mins
Everything you need to know about loans, what they cost, and how to apply.
Curious about how to apply for a loan but not sure what kind of loan will be best for you? Ponder no more. Here’s a comprehensive but brief explanation of everything you need to know about loans.
What is a loan?
A loan is a legal agreement you make to borrow money. Loans range from short-term loans that you can settle within a few weeks or months, to long-term ones like a home loan that you typically pay back over 20 years.
If you manage your loan well, it can help you pay for something you need today but can’t afford on the spot. The price of this convenience is that you’re committing to paying back the loan in monthly instalments plus interest, which means you will eventually pay more than you’ve initially borrowed.
Your credit score matters
When you apply for a loan and tell the bank or other financial institution how much money you need, they will always first do a credit check.
Banks pull a report from credit bureaus that shows a history of your debt and how well you’ve managed it. If you battled to keep up with payments in the past, it will also show in your report. A bad credit record could affect the loan that banks can offer you now – or in a worst-case scenario, they could decline your application.
If you have a good credit score, banks will then determine how much you can afford to pay towards monthly instalments. This is called an affordability check and is calculated by looking at how much money you want to borrow, how much you will have to pay back every month, and whether you indeed have enough extra money available to commit to a monthly instalment.
A way to lower your monthly instalments – and therefore increase the amount you can borrow – is to change the repayment period (the term of your loan). For example, if you borrow R5,000 and you pay it back over 6 months, you will have to pay about R1,100 a month. But if you pay it back over 12 months, your monthly instalment will be about R620. If you can’t afford R1,100 but can pay R620 a month, you should rather opt for a 12-month term instead of a 6-month term. If you go for 12 months, you will pay more interest, but it will improve your chances of getting the loan.
How much does a loan cost?
The cost of borrowing money is the interest that you pay on the amount you’ve borrowed as a yearly percentage. Your monthly instalment includes the monthly amount that you pay back towards the initial amount that you borrow (the principal debt) and interest (the monthly portion of the yearly interest that the bank charges).
Several factors influence the interest rate of a loan, including the kind of loan, the term of the loan, your credit record, the current repo rate (the rate at which the South African Reserve Bank lends money to banks) and whether the loan is secured or unsecured. An unsecured loan is not tied to any asset (guarantee or collateral), so the risk taken on by the bank is greater than the risk of a secured loan. To compensate for the increased risk, lenders charge higher interest for unsecured loans.
Among the biggest financial mistakes you can make is to miss a payment on a loan or credit agreement
Of all the factors that determine the interest rate you’ll have to pay, the one thing you have most control over is your credit score. A good credit record gives you a better chance of getting a loan at a lower interest rate.
At an interest rate of 18%, which is the average rate charged on most Nedbank personal loans, you’d pay R2,500 in interest over 12 months. If you cut the term to 6 months, you’ll pay R1,650 in interest. However, if you have a low credit score, you might be charged the maximum interest rate of 24.5%, and will have to pay interest of R2,700 over 12 months, or R1,800 over 6 months.
How do you pay back a loan?
Usually, you will have to pay your monthly instalments via a debit order linked to the account into which your salary is paid, which means the amount will be debited to your account automatically. When you get your loan offer, you will see how much you need to pay every month and for how long. You will also see how much interest you will pay over the term and if there are any other fees or charges, like monthly service fees.
What happens if you can’t pay the loan?
A big financial mistake you can make is to miss a payment on a loan or credit agreement. But sometimes ‘life happens’, and you might find yourself in a tight corner, not able to meet your obligations. The first thing to do when you realise that you’re going to have trouble paying an instalment is to let the bank know immediately. You might be able to extend the instalment or apply for a payment holiday, or you could arrange to catch up a few days later.
Banks may also restructure your loan (extend the term of your loan) so that you can pay less every month. That means you will end up paying more interest, but if the new instalment amount is easier to afford, you will avoid missing payments, which will damage your credit score. Telling your bank in advance is a good thing, and you’ll avoid all the extra stress of managing phone calls from debt collectors.
Banks are far more open to payment arrangements than taking legal action. So, make use of their goodwill by being upfront and arranging to catch up on your missed or late payments.
Types of loans
Loans come in all shapes and sizes for specific purposes. A student loan is different to a personal loan, which is completely different to a home loan. There are also various business loans available - a useful tool in the commercial sector.
The secret to managing your loan successfully is to understand what you’re getting into when taking out a loan
The biggest difference between loans is the interest rate and term of the loan. A home loan, for instance, is always a long-term loan that you’d normally pay back over 10, 15 or 20 years. Home loans also have the lowest interest rates, partly because of the long term, but also because the risk is lower. The bank owns the property until you’ve paid back the loan in full. That is why home loans and vehicle loans are considered secured loans. The assets are used as collateral and the bank owns the assets until full outstanding amount has been settled.
A student loan is not a secured loan, but someone must still stand surety for the loan amount. This means that if you do not pay your student loan, the person who vouched for you must pay it back. Student loans are also restricted, and you can use it to pay for tuition, accommodation, learning materials and books only. With a personal loan, you can spend the money on whatever you need.
Unsecured loans include personal loans, credit card accounts and overdrafts, and the bank does not ask for collateral. They are usually for smaller amounts, with personal loans capped at R300,000. Instead of collateral, an unsecured loan requires that you sign a legal agreement and commitment to pay back the money according to the terms and conditions of the loan.
Important loan definitions worth knowing
- Principal debt The initial amount you borrow
- Term The period over which you repay the loan
- Revolving loan A loan that enables you to borrow the amount that you’ve already paid again as many times as you need without applying for a new loan
- Interest rate How much banks charge as a percentage of the loan amount
- Fees Monthly charges related to initiating and maintaining a loan, which are added to your instalment.
What you need when you apply for a loan
To apply for a loan, you must be at least 18 years old and have the following documents:
- A valid South African ID
- Bank statements for the past 3 months
- Proof of your salary or proof of employment
How can you apply for a loan?
If you’re not an existing Nedbank client, it’s best to apply online at our website. But you can also phone us on 0860 103 582 or visit a branch. If you’re already a Nedbank client, it’s easiest to apply on the Nedbank Money app or Online Banking.
The secret to managing your loan successfully is to understand what you’re getting into when taking out a loan. Debt can be a good thing if you manage it well. Learning how a loan works and how it can help you is the first step towards staying in control.
Did you know that if you take out a personal loan and open a Nedbank Savvy Plus or Savvy Bundle Account, you can get R200 a month cash back for the duration of your loan? For an affordable loan tailored to your circumstances and value-added extras like cash back, choose the bank that’s best for your money.