4.3.2 Making borrowing decisions
Philip wants to purchase a music system costing £1000. If you assume that he cannot simply fund the purchase out of his monthly budget, his options include:
- using existing savings
- building up savings first, then purchasing the item later
- using a mixture of savings and debt
- taking out a debt of £1000.
The option Philip chooses will obviously depend on a number of factors including, crucially, his initial financial position.
For the rest of this week, you’re going to help Philip make the best choice. Start by running through some generic issues related to each option.
Option 1 involves using existing assets held as savings. If Philip has savings, he could draw on these to buy the music system. When deciding whether or not to use his savings, Philip may think about opportunity cost – the savings he uses to buy the music system will not then be available to purchase something else. He will also have to give up the interest he would have received on the savings spent on the music system. He might want to compare debt costs with the loss of income on his savings.
There are generally two reasons why the interest paid on a debt may be rather higher than income earned on savings.
- Savings products and debt products are provided by the same institutions – such as banks and building societies – and these institutions make their profits from the difference between the interest rates on the two products. In normal circumstances it’s likely that the interest rate for debt will be higher than the rate earned on savings.
- Interest on savings will be taxed as income unless there is a means of sheltering the earnings – for example, by saving in tax-exempt products. If savings are taxed, the rate of interest received after tax is likely to be lower than the interest paid for borrowed money. (Savings are covered in more detail in Week 5.) So, other things being equal, using existing savings will usually be cheaper than taking out debt to fund a purchase.
Option 2 is to build up savings before purchase. Again, this depends on having disposable income to allow savings to be built up. It also depends on Philip being prepared to defer the enjoyment associated with having a music system for the time it takes him to build up the savings. For the same reasons as Option 1, this second option is most likely to be cheaper than using debt to fund the purchase.
Options 3 and 4 both involve taking on debt. For the reasons already given, it’s likely that using a mixture of savings and debt would be cheaper than funding the purchase solely through debt.
For the sake of clarity, assume that Philip chooses to borrow the full £1000.