The Current Formula
Most consumers aren’t aware of the crucial fact that, as the repo rate is hiked, maximum credit interest rates rise at an ever higher rate. As follows, if you thought credit rates would only be 0.25% higher, after the July repo rate hike, you’re in for a rude awakening.
If you took out a personal loan and are repaying it at the maximum interest rate, you can expect to pay over 0.5% more. This is because the formula for calculating maximum interest rates includes a multiplier of 2.2:
RR (Repo Rate) x 2.2 + X%
Imposed by the National Credit Act (NCA), this formula only applies to non-mortgage credit agreements. However X will vary, depending on the credit agreement at hand. With a view to reducing credit rates, the National Credit Regulator (NCR) has proposed a new formula with a multiplier of 1.7, which could see consumers paying about 8% less. This proposed formula remains problematic, as it still includes a multiplier. As such, the effect of every repo rate hike on the maximum interest rate will be ever more severe, broadening the disparity between them.
Let’s say, you are paying a maximum interest rate of 20.2% on your credit card right now and the repo rate is at 6%, which means the difference between the two is 14.2%. Should the government’s proposed formula be approved, a repo rate hike of 1% up to 7% would cause your maximum interest rate to jump to 21.9%, and the difference would ascend to 14.9%.
Thereafter, you are faced with the repo rate climbing a further 1% up to 8%, which is to be expected, as the South African Reserve Bank (Sarb) goes ahead with its hiking strategy. This means that the maximum interest rate on your credit card would increase to 23.6%, making the difference between the two, 15.6%.
As you can see from the above examples, the relationship between the repo rate and maximum interest rate grows progressively disproportionate with each hike. In turn, presenting three devastating risks to the economy:
- Consumers defaulting – As a rule, when interest rates rise, so do consumer defaults on monthly credit payments. This is because, upon signing a credit agreement, most consumers have no clue how the upcoming repo rate hikes will affect their debt repayments. As affordability can’t be predicted with absolute certainty, many begin to default because they’re unable to afford their debt payments.
- Credit providers cashing in. The current formula leads to lucrative returns for credit providers. In addition, as credit providers borrow at a rate directly related to the repo rate, on the interbank market, but lend at a rate indirectly related to the repo rate, the system is eschewed in their favour.
- Banks going ‘bankrupt’. Maximum interest rates may rise to a point, where the sheer scale of defaults threatens the solvency of banks.
The Alternative Formula
Encouragingly, the DA has suggested an alternative formula without a multiplier:
RR + X%
Should this alternative formula be approved, it would have a wide-spread array of positive effects. For starters, it would mean that, when Sarb hikes the repo rate again, maximum interest rates would increase by the same or even a lower percentage. Moreover, this formula is clearer, simpler and easier to understand for the average consumer. So, when the next repo rate hike hits, you’ll be able to work out what your new credit payments will be and budget accordingly, so that you don’t default.
Not only will the risks to the credit market be mitigated, but poor and middle-income consumers will be protected from falling into a debt trap, if the DA’s formula is applied. Understanding how Sarb’s announcements affect your monthly payments is absolutely vital to your financial wellbeing, just as thoroughly reading through your credit agreements, before you sign them, is utterly essential.
The formula proposed by government simply will not do, as it doesn’t cater to the financially illiterate, nor does it protect the poor.