5.1 How to finance a purchase
Let’s look at the example of Philip, who wants to purchase a music system costing £1000. (We’ll assume that Philip cannot simply fund it out of his monthly budget.) In order to finance the purchase, options would include:
- using existing savings
- building up savings first, and purchasing the item later
- using a mixture of savings and debt
- taking out a debt of £1000.
Which option is chosen will obviously depend on a number of factors including, crucially, Philip’s initial financial position. Let’s start by running through some generic issues related to each of these options.
The first option involves using existing assets held in the form of savings. If Philip has built up savings, he could draw upon these to fund the music system purchase. In coming to a decision on whether to use savings, he may think about opportunity cost – the savings used to buy the music system will not then be available for him to purchase something else. He will also be giving up the future income, in the form of interest earned, on the savings that will be spent on the item. He might also compare debt costs with the loss of income on savings. Generally, you’d expect the cost of debt, in terms of the interest that will be paid, to be rather higher than income from savings for two reasons. First, 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 them. It is likely, therefore, that in normal circumstances the interest rate for debt will be higher than the rate earned on savings. Second, 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 likelihood is that the rate of interest received after tax will be lower than the interest paid for borrowed money. Thus, other things being equal, it would usually be the case that using existing savings will be cheaper than taking out debt to fund a purchase.
The second option is to build up savings before purchase. Again, this will depend on having disposable income above expenditure, which would allow savings to be built up. It also depends upon Philip being prepared to defer the enjoyment associated from having a music system for the period of time it takes to build up the savings. For the same reasons as the first option, this second option would most likely be cheaper than using debt to fund the purchase.
The third and fourth options both involve taking on debt. For the reasons given above, 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, in the rest of this section we’ll assume that Philip chooses to borrow the full amount.
What issues would Philip need to consider in our example of buying the music system?
Philip would need to consider the relative importance of buying the music system within the wider context of his existing goals. He would need to think about the constraints on his resources, and calculate whether repayments can be afforded within his household budget. In thinking through affordability, individuals should also consider the possibility that their circumstances may change. For instance, if household income were to fall or be interrupted during the term of the loan, could repayments be afforded?