Beware of High-Cost Credit

Perhaps the biggest financial irony is that the people who would benefit most from cheap credit actually pay the highest rates of interest. In other words, if you can’t borrow from mainstream lenders, then you have to turn to lenders who charge ‘telephone-number’ rates of interest.

Legal loan sharks

For example, payday lenders lend small sums of money for short periods (say, up to £400 for a month). For example,if you borrow £100 from Wonga.com you’ll pay back £136.72 after 30 days. This works out at an yearly interest rate of 4,214% APR (Annual Percentage Rate)!

You might think only the desperate and those in dire straits would use payday loans. In fact, an estimated three million Brits have borrowed from payday lenders in the past five years. It seem this business is booming, with the ‘subprime’ lending market expected to grow from £2 billion in 2010 to £3.5 billion by 2014.

Payday-loan pariahs

Last month, a leading lender decided to impose restrictions on borrowers who have used payday loans.

GE Money — a UK arm of giant US corporation General Electric — will no longer lend to borrowers who have taken out payday loans within three months of applying for a GE home loan. GE Money will also reject borrowers who have used payday loans twice or more in the previous 12 months.

The American lender will turn down mortgage applications from these borrowers even when they have repaid their payday loans in full and on time. As GE Money specialises in lending to customers with imperfect credit records, this sends a powerful message to other lenders.

As a result, GE Money has been requesting data on payday loans since May from credit reference agencies such as Experian. GE Money warns,

“As a responsible lender in a challenging market, we review a range of data to make prudent mortgage-lending decisions. Payday-loan data is one of many items included in this review, and if a mortgage applicant has a current, or had a recent, payday loan, it is unlikely that we will consider their mortgage application.”

Risky business

As an ex-banker, GE Money’s decision seems utterly sensible and prudent to me, as payday loans can be interpreted as indicators of financial stress.

Why risk lending upwards of £100,000 to homebuyers who are unable to budget properly and make their wages last? Surely, if these people often have ‘more month than money’ and cannot pay their everyday bills on time, then they are unsuitable candidates for home loans?

GE’s move may be just the tip of the iceberg, as Kensington Mortgages has recently adopted the same approach. Indeed, I expect more and more lenders to exclude applicants who rely on short-term, high-cost lending to support their everyday lives. While GE and Kensington are the first mortgage lenders to reject payday borrowers, other lenders are sure to follow.

Four future red flags?

As lenders cherry-pick the best borrowers, more and more high-risk credit products could ‘turn toxic’ and put a black mark against your credit record. These four products could become future warning signs for lenders:

1. Subprime mortgages and secured loans

During the Noughties boom for credit and house prices, lenders would lend to anyone with a pulse. This led to huge growth in subprime mortgages and secured loans — loans for people with tarnished credit histories.

However, since the credit crunch arrived in August 2007, subprime lending has collapsed to a tiny fraction of its former size. Today, lenders worry more about the return of their funds than the return on them.

As a result, borrowers with home loans, second mortgages and secured loans from subprime lenders could find themselves locked out by mainstream lenders in future. When these people come to move home or remortgage, they could be turned down because of their subprime past.

2. ‘Credit rebuilding’ credit cards

Many high-interest credit cards offer novice or risky borrowers an opportunity to build up or rebuild their credit histories. These ‘credit rebuilding’ cards include the Aqua Reward card (34.9% to 49.9% APR; pays 3% cashback up to £100 a year), the Vanquis Bank card (39.9% to 59.9% APR) and the Capital One Classic Extra card (34.9% APR; 0.5% cashback and £10 yearly bonus).

As these credit cards charge high rates of interest, you should always pay them off in full every month, ideally by direct debit. Also, if you miss any repayments or pay late, then this will harm your credit rating. In addition, never withdraw cash on these cards, as the fees and interest charged are staggering.

Right now, these are viewed as credit-rebuilding cards, but this situation could well change. In future, it’s possible that these cardholders might be unable to access mainstream mortgages and other credit.

3. Unapproved overdrafts

When you go overdrawn without authorisation, or exceed your approved overdraft limit, you’ll be charged interest at rates of up to 30% APR. Also, every time a payment is ‘bounced’ (rejected) or you increase this unauthorised borrowing, you’ll be hit by sky-high fines of up to £40 a time.

These penalties and interest rates make unauthorised overdrafts a cripplingly costly way to borrow, especially over the longer term. If banks further tighten their lending criteria, then going into the red without approval could count against you when applying for future home loans and other credit.

4. High levels of personal debt

Of course, when lenders size you up as a potential borrower, they always check your existing levels of debt. You may have a perfect credit record and never missed a single repayment, but living the high life on loans and credit cards will definitely count against you.

For example, if you have unsecured debts of, say, half (50%) of your salary, then you will have a much reduced chance of getting a mortgage. So, always remember that you are given credit limits, not targets!

Keep your record clean

In summary, if you’re saving to buy a home and want to keep your credit record spotless, then don’t do anything to scare off potential lenders. Keep your finances in order and your household budget on track — and don’t be tempted to borrow at sky-high rates of interest, even for short periods.