5.2 Which debt product?
Philip may or may not have been thinking through all of the issues discussed above, but we have assumed that he is going ahead and wants to fund the purchase by taking out debt. Philip will then need finance, and the debt product which is used will depend upon a number of factors, including price, flexibility and the length of time over which repayments are made. Box 6 describes the different debt products.
Box 6 Debt products
- Overdrafts: These provide a flexible means of accessing debt on a bank current account, up to a limit approved by the lender. Unapproved overdrafts normally attract penalty fees and higher interest charges than approved overdrafts.
- Credit cards (including store cards): These will have a credit limit set by the lender and normally require a minimum amount to be repaid each month – typically between 2 per cent and 5 per cent of the balance of debt. Prior to the time when the payment is due, there may be a short period of interest-free credit. Credit cards will vary widely in the interest rate charged on the balance that is not paid off, and some may have an annual fee attached, although many do not. Store cards are a form of credit card which may only be used for buying from specified outlets, and the interest rate charged on store cards tends to be much higher than that of credit cards.
- Charge cards: These can be used like credit cards to make purchases and obtain up to around two months’ free credit between purchase and paying off the outstanding amount. The difference from a credit card is that, with a charge card, a borrower is required to pay off the entire balance each month. The two-month free credit period arises from the fact that the charge card bill will be sent out monthly, with up to around a further month to settle the bill. A fee may be payable for the card. A famous brand of charge card is the American Express charge card.
- Personal loans: These are loans, typically of terms between one and ten years, which may be either unsecured or secured against a property (such as a house) or other assets. Unsecured personal loans are not contractually linked to any assets the borrower buys. These are available from credit unions, banks, building societies, direct lenders and finance companies.
- Hire purchase (HP): This is a form of secured debt where hire payments (interest and part repayment of the principal) are made over a period, normally of up to ten years in order to purchase specific goods. The legal ownership of the product only passes to the borrower when the final instalment has been paid.
- Mortgages: These are loans to purchase property or land, and are secured against these assets. Debt terms for mortgages are normally up to twenty-five years. There are many different types of mortgages and, as mentioned in Section 2.1, it’s possible to fund spending through equity withdrawal. Since the financial crisis, however, lenders have become more cautious about equity withdrawal, particularly in the wake of the decline in average house prices after 2007.
- Alternative credit: These are the areas of sub-prime lending described in Box 1, and include buying on instalments through mail-order catalogues, doorstep lending and lending on the high street. Commonly, interest rates are high and there are heavy penalties for late payment. In fact, one report found that a fifty-week loan for £400 from one of the weekly-collect credit companies would cost £700. The same report found that a £400 loan from an unlicensed lender could cost up to £2000 in repayments spread over six or more months (Kempson, 2001).
In terms of price, as Section 3.4 noted, the APR can be used to compare the costs of different debt products. One first possible step for Philip might be to gather information on different APRs. Sources of information include adverts and offers for loans in newspapers, on television, radio and the internet, the finance sections of newspapers, or financial advisers.
Connected to price is whether the debt product is secured or unsecured. One trend in recent years, encouraged by advertising, has been for individuals to consolidate a number of unsecured debts in one loan, usually secured against a property, and thus withdrawing ‘equity’ from that property. The attraction of doing this is that the mortgage rate – which tends to be the lowest of the rates charged on the different forms of debt – may now be applied to all debts and the term of debts may be extended, reducing the size of monthly repayments.
However, there are risks in adopting this course of action because swapping existing loans for a consolidated loan increases the risk of losing one’s home. Additionally, if consolidating debts in this way involves extending the term of indebtedness, there is the possibility of a mismatch between the life of the debts and the life of the assets acquired. Therefore, for example, if the music system was expected to need replacing in five years but the debt was repaid over ten, Philip might still be paying for a music system which was no longer in use. None the less, consolidating debts is popular: a survey of borrowers conducted on behalf of the Bank of England in 2004 (May et al., 2004, pp. 420–1) found that 25 per cent of respondents who took on an additional mortgage did so to fund the consolidation of debts.
The price of the debt product is clearly important when making a decision on which product to choose. Indeed, an accurate price is essential for household budgeting and planning ahead, but it’s not the only factor. A second issue is flexibility. For instance, Philip might find that debt through hire purchase (HP) is cheaper than debt through an unsecured personal loan but, because HP tends to be tied to a particular deal, there may be less flexibility in shopping around for a particular commodity or brand.
Credit cards offer a flexible way to borrow, but interest rates can be high. You saw, in Section 2.1, that possessing and using credit cards is very popular in the UK. One feature of the credit card market is the use of discounts to attract new customers. These may be in the form of ‘low start’ loans, where the initial rate charged is lower than the standard rate, but with the cost rising to the standard rate after the introductory period. One extreme example of this is where credit cards are offered at an interest rate of zero (0 per cent) for an introductory period, including for sums of existing debt transferred to the card. These rates are designed to encourage customers to move from one lender to another or, in fact, to take on debt which might not otherwise have been contemplated. If a debt product has an initial discount, borrowers need to calculate whether they can afford the rate which will apply once the discount period ends.
A third issue when choosing a debt product, and which contains both elements of price and flexibility, is deciding over what term to borrow. Table 2 uses an example of borrowing £1000 on a repayment loan at 6.7 per cent APR to illustrate the difference this makes. In this example, taken from a high-street building society, total repayments vary from £1035.48 to £1173.60. Because it is a repayment loan, the interest charged is calculated on the average balance of the principal outstanding, as discussed in Section 3.1. Although the monthly charge (and hence the expenditure in the household budget) is higher per month for a shorter loan, the total cost of repayment is less.
Table 2 Examples of borrowing £1000 at 6.7 per cent APR
|Repayment period||Monthly payment (£)||Total amount paid (£)|
|1 year (12 months)||86.29||1035.48|
|3 years (36 months)||30.65||1103.40|
|5 years (60 months)||19.56||1173.60|
Consequently, price, flexibility and length of term are all important factors in choosing a debt product. This is all significant information needed in any financial planning process about the taking out of debt. However, the notion of choice itself is influenced by the social and economic circumstances of individuals such as Philip. As we saw in Section 2.1, low-income groups have only limited access to mainstream finance: in fact, this is one of the characteristics of financial exclusion. People who do not own their own home, for instance, will not have the same access to secured lending as homeowners. This narrows their ability to access the kind of low interest debt which is associated with secured lending. Such individuals might, of course, choose not to borrow to fund a music system purchase, but any borrowing they do undertake would most likely involve more expensive forms of debt than homeowners can access.
The data below show some real-life interest rates for different products in a high-street lender in August 2010. Given that the rate for the personal loan is substantially the lowest, why might someone use any product other than a personal loan to buy the music system?
|Debt product||Typical APR (%)|
When choosing a debt product, many of the aspects you’ve seen in Box 6, and in Section 5 generally, will be important, such as flexibility, convenience, the desired term of repayment, and the price (the interest rate). Another factor that may influence someone’s decision is how these different financial products are marketed. Therefore, many factors other than the price will play a part in selecting the specific debt product, and that is why the personal loan, which is the cheapest, may not always be the product chosen.