OPINION – The debt trap: How to escape the vicious cycle of mobile loan apps
By Reginald Kadzutu
There has been a proliferation of easy loan products and use of digital credit in the Kenyan market riding on the pervasiveness of mobile money transfer services.
Unlike traditional lenders which have stringent conditions, mobile app loans are instant, require zero paperwork and use alternative credit scoring models such as mobile money transaction data to determine eligibility for credit. What could be more convenient and enticing!
Statistics from platforms such as M-Pesa, Timiza and Fuliza show the huge appetite for loans running into hundreds of billions of shillings.
Debt helps drive consumption and demand which in turn drives economic growth and general social well-being; however if abused debt leads to unintended consequences.
Unfortunately, that has been the case in Kenya where there is debt pile up both on the government and individual level with no corresponding leverage results. The cries of people who are now deep in debt traps are becoming louder and louder with disastrous effects on the socio-economic fabric of the country.
One rule of thumb for borrowing is that you are trying to leverage the results of your own capital to generate more revenues and the key word there is your own capital. You need to have your own capital to leverage on.
The second rule of thumb on borrowing is that usage of debt should generate enough cash inflow streams to cover the principle and cost of the debt.
How do people find themselves in a debt trap?
Lack of planning
As an individual or company, failure to plan for upcoming expenditure or expansion puts you in a position where you need to borrow without following the two rules of thumb. A common scenario is how the debtor creditor paradox causes many startups or SMEs to fail under a heavy load of debt and a mismatch between cash inflow and cash outflow.
For instance an SME making sales may realise that the good tender they won only pays in 90 days. Having borrowed credit from suppliers for 30 days, the entrepreneur is forced to find money to pay the creditors and continue running the business to meet demand for another 60 days with money that has not been received.
Planning your future financial obligations and goals helps an individual or a company know how much to save or how much profits to retain.
Living Beyond your Means
What credit cards or e-credit cards do, is extend your purchasing power beyond your normal income level, with a promise that it is free if you pay up in time. However therein lays a trap to enter a vicious cycle.
The reality is that you cannot pay it up because your income was never enough to afford it in the first place. Your income for the next month is reduced by the amount that has to pay for the credit card, meaning you might have to use the card again to cover that hole.
For businesses the disease is normally over expansion. A business finds that there is demand for its products or goods and decides to go for the kill by expanding using debt, to either up production or open branches. If the cashflows do not come in as expected, the company starts paying for the debt using existing revenue and ends up with scenarios such as Uchumi and Nakumatt.
Here’s how to avoid getting trapped in debt:
Create a solid financial plan. Track where your money goes to capture all your expenditure and identify areas of concern that are against your budget. Subsequently, create a repayment to help you get out of debt fast. Doing so not only helps you address your current predicament but also creates a viable solution to your financial problems.
Prioritise your needs. Here is where the guilty pleasures come into play. To avoid the debt trap you may want to refrain from purchasing non-essential items which are not critical to survival but only add to your comfort. Create a priority list to segregate your needs and avoid spending on non-essentials or find cheaper alternatives.
Build an emergency fund. While it is important to save money, you should also create a special fund to sustain you during emergencies. With an emergency fund, you can comfortably manage your expenses and navigate tough times without having to fall back on a loan.
Use borrowed money to create wealth. Most borrowers use digital credit for medical expenses, household needs or to offset other loans. This shows that most borrowers spend the loans on consumption rather than generating more income, forcing some to be perennial borrowers. The best strategy to avoid the debt trap is to create value from your loan rather than just spending the money.
Although taking a loan can alleviate a pressing financial matter, there is always a risk of getting trapped in debt. The first step to achieving financial freedom is through saving which starts by establishing your financial goals. Remember, if you cannot pay for it cash, you cannot afford it.
Reginald Kadzutu is the Chief Investment Officer at Amana Capital Ltd