Personal Financing: 

There are two main forms of personal finance and investment, self-financing and credit financing.

Self-financing (Savings): Savings are delayed spending by individuals. These savings can be invested to earn interest which creates additional savings.  When spending is financed through savings it is known as self-financing.

Credit financing,

Credit Cards: Credit cards allow individuals to buy now and pay later. There are various credit card facilities and these facilities vary in the interest-free period available and the fees charged to have this facility. 

 

Overdrafts: Overdrafts are a method of financing used mainly by businesses. However, some individuals are able to finance transactions/purchases via an overdraft facility. An overdraft is when a bank allows the customer to withdraw, up to an agreed value, more money than the customer has deposited in the bank. Although this is an expensive way to borrow, the customer pays interest charges only on the value overdrawn while still having access to additional funds up to the agreed value. This means that an amount agreed to by the bank in advance can be ‘drawn down’ by the customer at a later date.

 

Loans: There are many forms which loans can take. The most common types for individuals are mortgages, personal loans, equity loans and investment loans.

• Mortgages: are loans secured by assets, typically a house or property. Fixed rate loans are loans where the interest rate does not change for a number of years. After that period, the rate may be renewed at the same rate, converted to a variable rate or set at another fixed rate for another period. However, changes to this type of loan often incur charges by the bank. Low start loans have a low interest rate in the early years of the loan as an enticement for borrowers. After that period, the loan is moved to a variable rate. Interest only loans are loans which only interest is paid for the whole life of the loan. The full amount borrowed is paid at the end of the loan’s life.

• Personal Loans: are borrowings from a bank, financial institution or other source. This loan allows the individual to enjoy a service or use of an item purchased whilst repaying the loan in regular instalments. E.g. Holidays, dental/medical procedures.

• Equity Loans: are borrowings against the equity a person has (e.g. house/ other property). Equity is the difference between what a property is worth and what is owed on that property. It can be possible for an individual to borrow against this equity to renovate, invest in shares or buy another property.

• Investment Loans: is generally a loan for investment purposes such as rental property, share portfolios, stocks/bonds. This type of loan is usually an interest only loan. The principal (full amount borrowed) is not reduced. This type of loan is generally low-cost and can be a tax-effective way to invest.

• Leasing & Hire purchase: A lease allows for the use of an asset without the cost of purchasing the item. The item is usually ‘rented’ for a monthly fee and this may create a tax relief opportunity for some businesses. At the end of the lease agreement, the lessee may have the opportunity to purchase the item. Whilst, hire purchase is similar to leasing. It is most commonly used to purchase furniture and white goods (large electrical goods e.g. refrigerators). As well, the item is usually paid in monthly payments and ownership of the goods is transferred to the hirer at the time the contract conditions have been fulfilled.

 

All of the above loans carry some level of benefits and risk. When market conditions are favourable, the risk is low, but the risk rises when the market is falling.

 

Advantages and disadvantages of credit financing

Most of the types of financing described here are credit financing, which follows the principle of ‘buy now, pay later’.

Credit financing has the following advantages:

• provides immediate use of the item purchased

• provides emergency funds by freeing up cash

• reduces the need to carry cash

• provides an opportunity to purchase items when the best deals are being offered.

 

The disadvantages of credit financing are:

• Interest and charges must be paid as well as the principal of the loan used to purchase the product

• It encourages impulse buying

• Debt can increase beyond the person’s capacity to pay.

(Source: Accounting Concepts and Applications 4th edition, Phillipa Greig, Joan Mackay, Stacey Beaumont, Rosette Sanger, 2008)