Bayport Blog

Formal or informal – which loan should you choose?

Almost everyone needs a loan at some point. It could be as informal as borrowing R50 from a friend to pay for a meal, or as formal as signing a multi-page loan agreement with a bank or a micro lender. Whatever the circumstances, you must always make sure to avoid bad debt when you borrow money.

People have been borrowing money for thousands of years. Before there were banks, loans were informal arrangements, usually between people who knew each other. Sometimes collateral was required, and sometimes not. Interest was charged, people got into bad debt, and some credit providers used rather brutal methods to get their money back.

The arrival of the formal banking system gave people other options when it came to financial services, and these days institutions are increasingly regulated to protect consumers.

However, many people in developing countries – such as South Africa – find it difficult to access formal financial services, and even those who can open an account or take out a formal loan, still sometimes prefer to go the informal route.

Let’s take a closer look at formal vs informal lending, and the factors you should consider when opting for one or the other.

In simple terms, formal lending takes place between two parties who have a business relationship and always involves a written contract. It can be an unsecured personal loan or a loan for which you have to provide collateral. Formal loans are usually provided by a bank or an unsecured credit provider, but can also be in the form of a store account.

Advantages:

• You agree upfront how much you are borrowing, at what interest rate and any other fees that will be charged. You know that your monthly repayment is and by when the loan will be settled. All of this information is captured in a contract that both parties sign. As a result, you know exactly what you are getting into and how much the loan will cost you.
• The contract protects you and the credit provider.
• If the credit provider is registered with the financial authorities (you should never borrow from an unregistered company!) you are further protected by legislation such as the Consumer Protection Act and the National Credit Act.

Disadvantages:

• If you default on your loan, additional fees will be charged, which will make the loan more expensive.
• Any defaults will reflect badly on your credit score, making future credit more expensive or even impossible to get.

An informal lending agreement is most often between people who know each other – such as friends or family members – and very seldom involves anything in writing. You can also get an informal loan from someone you don’t know, also with no paperwork involved. These lenders are called loan sharks or mashonisas, and they are the dark side of informal lending.

Advantages:

• If you borrow from a friend or family member, chances are you can get an interest-free loan, which saves you a lot of money.
• Informal loans are quick and easy to get, because there is no paperwork involved.
• Should you default, your credit score will not be affected.

Disadvantages:

• If something goes wrong with a loan from a friend or family member, it could damage the relationship to the point where you lose a friend or cause a family fight. For this reason, it is always best to draw up a simple agreement that stipulates at least the amount borrowed and how the money will be repaid.
• When you deal with a loan shark, you have no recourse – there is no organisation where you can complain or that can protect you. If the loan shark decides to charge more interest or threatens you or your loved ones, you have to deal with the situation on your own.
• In the absence of a contract, loan sharks charge exorbitant interest on loans and often take your ID or bank card until you have repaid your loan.

Informal loans can be extremely handy, especially when you need the money for a very short period of time, and you know you can pay it all back within a few months, or even a few days. In any other circumstances, a formal agreement is always better.

Of course, first prize is that you should have an emergency fund that you can use, instead of borrowing money. If you don’t already have one, start saving money (even if it is just a small amount) right away.

For more information on personal loans, visit https://www.bayportsa.com/products-services/personal-loans-online/

For more information on personal loans, visit https://www.bayportsa.com/products-services/personal-loans-online/