You know that when the repo rate increases, the cost of credit increases. But did you know that the cost of credit doesn’t increase at the same rate as the repo rate? It increases at a higher rate. So when the repo rate went up 0.25 percentage points in July, you would have received a rude surprise if you were expecting to pay only a quarter of a percent more for credit. If you have a personal loan and you’re being charged the maximum a credit provider may charge you, you would have found that you’re paying just over half a percent more in interest.
The reason for this discrepancy is the formula used to calculate the maximum interest rates that credit providers can charge you (for non-mortgage credit agreements) in terms of the National Credit Act. This formula is not at all user-friendly, but stick with me: this affects us all.
The formula is RR (the repo rate) x 2.2 + X percent (the X varies according to the type of credit agreement). The National Credit Regulator has proposed reducing the “multiplier” from 2.2 to 1.7.
If the Minister of Trade and Industry accepts this proposal, it will result in a reduction in the maximum interest you can be charged on non-mortgage credit agreements. For unsecured loans, you could be paying almost eight percentage points less.
So what’s the problem? While no one would object to paying less interest, there are those who object to a formula that includes a “multiplier” (which the existing and the proposed new formulas do). The problem with such a formula is that, as interest rates increase – and they are expected to – the effect of the multiplier becomes more and more severe, widening the gap between the repo rate and maximum rate you can be charged, Geordin Hill-Lewis, a Member of Parliament for the Democratic Alliance, says.
For example, assuming the government’s proposed new formula is accepted, you could be paying a maximum of 20.2 percent interest on your credit card now, while the repo rate is at six percent. The difference between the repo rate and the maximum interest rate in this case is 14.2 percentage points.
But if the repo rate increases by one percentage point, the maximum interest rate rises from 20.2 percent to 21.9 percent (by more than one percent) and the difference between the two rates increases to 14.9 percentage points.
If the repo rate increases by another percentage point – to eight percent – the maximum interest rate rises from 21.9 percent to 23.6 percent and the difference between the two is now 15.6 percentage points.
This shows the disproportionate relationship between increases in the repo rate and the maximum interest you can be charged.
This is not consumer-friendly.
“When the Reserve Bank increases the repo rate, many South Africans are totally unaware that the interest rate they will pay on their credit card, store card and/or personal loan is actually going up by even more than the repo rate,” Hill-Lewis says.
When signing a credit agreement, most people would not be aware of this. “Even if they are explicitly aware of it, it is very difficult for them to make an informed decision about whether to accept the credit or not, because it’s too complicated to work out the effect of future repo rate increases,” he says.
This introduces three significant risks to the credit market, Hill-Lewis says. They are:
* The risk of default. “Usually when the interest rate increases, so does the default rate,” Hill-Lewis says. The formula used to calculate the maximum rates exacerbates the problem, he says, because consumers can’t work out how interest rate increases impact their debt and therefore they are more likely to default.
* The “moral” risks. “The formula results in a significant increase in the profit margins of credit providers, which introduces more moral hazard in the credit system,” he says. With the existing formula, banks benefit from increases in the repo rate because they borrow on the interbank market at a rate directly linked to the repo rate, but can lend at a rate that is indirectly linked to the repo rate, he says. “This is a perverse incentive in the system.”
* Systemic risk. “Once the maximum interest rate rises beyond a point, defaults will reach a tipping point, at which credit providers’ solvency will be put at risk. More research must be done on the extent to which this played a role in the collapse of African Bank when the interest rate began ticking upwards. It undoubtedly played a role in the huge increase in defaults observed in late 2013 and early 2014,” Hill-Lewis says.
In response to an invitation from the Department of Trade and Industry (DTI) to comment on the proposed changes to the formula, the DA has proposed an alternative formula, which does away with the multiplier: RR + X percent.
The effect of the DA’s proposal is that the maximum interest rates would be equal to or lower than the maximum rates that would apply under the government’s proposed new formula.
“The more important effect is that any increase in the repo rate is matched with an equal increase in the maximum rate. This is much more transparent, easy to understand and makes it easier forconsumers to predict the effects [of a repo rate hike] on their monthly payments,” Hill-Lewis says.
He says the government’s proposed new formula “does little to protect the poor and financially illiterate consumers from confusing and opaque credit agreements”.
Many South African consumers of credit are financially illiterate, do not properly interrogate the contracts they sign, and do not understand how the Reserve Bank’s announcements affect their monthly payments, he says. That’s an understatement, in my opinion. I would say this describes “most” consumers of credit in South Africa.
Hill-Lewis quotes research by FinMark Trust, which found that 65 percent of consumers of non-mortgage credit earn less than R8 000 a month, and 90 percent earn less than R12 000 a month.
FinMark Trust research also shows that 48 percent of all non-mortgage credit agreements are charged at the maximum interest rate. “This was prior to the collapse of African Bank. The figure is probably higher now, owing to less competition in the market,” he says.
The DA says its alternative method of setting the maximum interest rates will help poor and middle income consumers of credit avoid a debilitating debt trap, provide for credit agreements that are clearer and easier to understand, and reduce risk from the credit market.
I’m neither poor nor financially illiterate, and I have struggled to get my head around this. What hope is there then for the domestic workers, factory workers or even the “knowledge workers” who contact Personal Finance for help with their debt problems?
DTI spokesperson Sidwell Medupe says it would be premature of the department to provide a view on the DA’s submission. All submissions received by the DTI are being analysed. Recommendations will then be made to the minister to make a final determination. “There won’t be publication of another proposal for comment,” he says.
Personal Finance asked what the rationale was for using the existing formula, which includes a multiplier, but Medupe declined to answer the question.
Hanri Els, who did a recent study on unsecured lending for his MBA dissertation, says the formula should correlate with economic factors, such as gross domestic product, unemployment and wage increases.