Importance of Personal Debt Planning

Today, people have more money than they did 10 years ago, however, the knowledge on managing these finances has not kept pace (Maura Fogarty 2012). Planning and managing finances is a duty of every individual whether earning or not. Hence, students too have to manage their finances. Managing finances not only helps an individual to set up their budget but to also invest well and plan for their retirement. This essay will explore debt, importance of personal debt planning, costs of acquiring debt and the process and the economic influences in debt.

Importance of debt financing in the context of personal finance

Personal financial management is handling money and properties in a responsible way to attain independence (Muske and Winter, 2013). The process helps individuals to manage their homes and it includes budgeting, saving, investing, debt management and other aspects associated with personal money. Hence, personal finance is the process of controlling income and organizing expenditures through a comprehensive financial plan. Debt financing refers to a situation where a person takes money to be paid back at an upcoming date with interest. Debt, therefore, is the amount of money that needs to be refunded and financing is giving funds to be used in business undertakings. There are several benefits of debt financing in the context of personal finance as follows:

First, debt financing makes sure that the right amount of money is obtainable and in the right hands at the point of time in future to achieve particular financial objectives (Zucman 2014). Individuals set financial goals which they may be unable to meet with their savings. Hence, debt enables them to meet these objectives by availing the necessary capital. For instance, most people own homes through mortgage, were it not for this type of debt financing, these households would not have managed to own homes. Hence, debt financing aids in attaining set financial goals.

Second, personal debt helps individuals enroll in college and attain a level of education which they cannot do on their own. Individuals use student loans to further their careers and then repay the loans after they have graduated and secured jobs. Debt financing therefore not only helps individuals attain financial goals but also educational ones. Third, through debt financing, many individuals have managed to own cars. A car has become a necessity in the UK, hence many people are wishing to own the asset but they are unable due to limited savings. Debt financing is helping such people to secure the asset. Fourth, debt financing helps during periods of emergency especially when one cannot use their credit cards to solve the issue. Debt financing acts as a financial aid during emergencies which cannot be solved by using savings or when one does not have adequate emergency fund. Thus, debt financing is beneficial to households because it not only enables them to purchase assets such as homes and cars, it also enables them to meet their financial goals and relieve pressure during times of financial emergencies. Moreover, debt enables people who do not have upfront cash to improve their standard of living such as through purchase of a car.

Different types of debt financing

Debt financing can be classified into four main categories; unsecured vs secured debts and instalment vs revolving debts. A secured debt is one which is borrowed using collateral or security (Ponticelli 2015).  In some instances, individuals cannot be given loans if they lack collateral as a fall back plan in case they are unable to repay the loan. Examples of secured debts include car loan and mortgage. Unsecured debt is the type of loans which do not require collateral. Unlike car and mortgage, some loans do not require one to have security and in case one is unable to pay their debt, the lender can either threaten or penalize by adding high-interest rates or pursue legal action. Unsecured credit is good because the borrower does not risk losing any of their precious assets since the debt is not backed by collateral. Moreover, unsecured debts attract higher interest than the secured ones because, in the former, the lender assumes a high risk.  Examples of unsecured debts are credit card debt.

Instalment debt is one where the borrower has an idea of the amount of money they are supposed to pay each month. There is a fixed amount of money repaid to the lender every single month hence making it easy for the borrower to plan their finance. Examples of instalment debts are mortgage and car loans in which a predetermined amount is paid every month. Revolving debts, on the other hand, refer to debts in which there is no ascribes monthly payments. The borrower, therefore, has the difficulty of determining the amount they should pay every month because it depends on a given percentage of the total money you owe on a given month.

The most common kinds of debts are credit cards, medical debts, student loans, mortgage, cell phone bills, payday loans, auto loans and home equity loans.  

Credit cards

Credit cards are unsecured debts which have no collateral, thus when a borrower defaults, the creditor hires debt collection agencies to recover the money. The creditor can also choose to file a lawsuit against the borrower. The credit card is issued upon agreement with consumers that any unpaid interest will continue to accrue interest until it is paid in full.

Student loans

In the UK, universities charge tuition fees for the cost of running their undergraduate courses. The fees are set at varying levels based on the student’s place of origin. In average universities in UK charge up to £9,250 per year (Times Higher education 2018). This amount may be difficult for some students to pay hence they take up loans. The students’ loans in UK incur up to 6.3% per annum which has recently increased due to rise in inflation (Partington 2018).

Mortgage

A loan used to finance purchase of a home or property. The borrower promises to slowly repay the amount of money taken with interest and over a particular timeline. Mortgage is a secured loan in which the borrower uses the property being purchased as collateral. In most cases, mortgages are given by banks or other financial institution who typically loan at least 80% of the price of the property being purchased. If the borrower fails to clear the loan, the lender can foreclose the home and sell it to recover the amount of money defaulted. There are different types of mortgages one of them being fixed rate which the borrower makes same payment for the entire life of the loan. These mortgages typically range from 15 to 30 years but the terms may differ (Kohler 2017). The other type of mortgage is adjustable rate where the interest may change at some point. When the rate of interest changes, monthly payments change as well. The loans are risky because the borrower does not know what the next monthly payment will be. Second mortgage is the third type of mortgage loans which allows a borrower to add another mortgage and borrow more money. The second lender only gets paid if there is money left over after the first mortgage is cleared. Reverse mortgage is another type which is used to supplement income or get lump sums of cash out of a property. Instead of the homeowner paying the lender every month, they convert the part of equity of the house into cash. The arrangements in reverse mortgages are complicated hence attracting many risks. The last type of mortgage is refinancing which the borrower gets a new mortgage which pays off their old loan.

Home equity loans

This type of loan allows individuals to loan against the equity of their houses. The loan can provide money for major purchases but is associated with risk of losing the home if one is unable to pay the loan. The loan is secured through a house and has a fixed rate hence interest does not vary during the duration of the loan. Home equity loan can be used to borrow money for home repairs, pay off credit card debt or finance college education. The loan, however, cannot be used for purchasing a home because the borrower should already have a home which they are using as collateral. The home is appraised and the loan issued is dependent on the value of the home.

Home equity line of credit

This debt is different from home equity loan in that it does not have a fixed interest rate. The home equity line of credit is a volatile loan due to adjustable rate. The lender agrees to give the borrower a specific amount of money to be repaid at a particular date at a given rate. If the borrower fails to repay the loan, the home is foreclosed and sold by the lender.

Payday loans

Payday loan is a secured loan with an average of 14 days and rarely taken out for more than one month. The loan is used to help an individual wait for the next payday. The lenders set the due date as the next day of the borrower payday.

Auto loans

An auto loan is taken to aid in purchase of a motor vehicle. The loans are structured as instalment loans and secured by value of the asset being purchased. The loan is secured by the value of the motor vehicle under purchase. If the borrower fails to clear the loan, the motor vehicle is seized and sold to recoup the losses.

The debt borrowing process

Households follow six main steps in asking for a loan. First, they save up some deposits which can be used to increase their credit record. In case of purchase of property, the saved amount is used as deposit. Second, the borrower approaches the lender who can be a bank or any other financial institution offering loans. Third, the lender assesses the borrower’s application and any supporting documents to build up a picture of how they will manage their finances. Among the factors considered is the size of the loan, how much they have deposited, incomes, household bills and any other financial commitments of the borrower. The fourth stage is valuation which mostly occurs when taking a mortgage. The lender consults an independent surveyor who values the house to determine if it is priced correctly. The fifth step is the offer where the lender gives the borrower an offer depending on the evaluation conducted. The last stage is completion which is signalled by signing of contracts.

Key economic influences in debt

Consumer debt also known as household debt is a topic which has received a lot of scrutinies but mostly because of the significant risk it poses to the financial health of global economy especially to developing countries. The high growth of household debt level is influenced by several primary factors:

Interest rates

The cost of servicing a debt is determined by the size of the original loan, interest rate on the loan and the length of time it takes to repay the loan. When interest rates are low, the cost of the loan goes down making debt more affordable hence attracting more borrowers. When the interest rate is high, the cost of debt goes up making it expensive for many people to afford thus reducing the level of debt in the economy. In the UK, the cost of servicing a debt is much lower than it was before the 2008 recession. For instance, interest rate on personal loan is 4% a decline from 10% in 2010 (Harari 2018).  Mortgage rates have also declined from 4% to 1.4% although they have slightly risen in 2018 (Harari 2018). As these rates have reduced, consumer debt has increased by 4% in March 2018 with mortgage loans comprising a 3.3% rise (Harari 2018).

This low rate has enticed people to take up more debts leading to high debt levels.

Investor activity in the housing market

High investment activity in housing market increases buyer competition which results in prices. The rate of home ownership in UK is 69% compared to 67% of USA and 64% of Canada (ABS 2018). The high rate in UK is because property investment has been seen as a profitable activity, there are tax considerations, accessibility of a wide pool of differentiated banking products appropriate to investors such as home equity loans and money being more easily accessible due to the deregulation of the financial sector.

Income and employment growth

When the rate of employment in an economy is high and people are earning more income, they tend to afford housing thus increase in demand for houses which in turn increases their prices. As income and employment rises, more households are able to buy houses and the existing owners have augmented capacity to trade up higher quality housing thus increasing household debt.

Lending policies and practices of finance providers

When the lending policies are favourable, they entice households to borrow more hence increasing the debt level than when the policies are strict. For instance, in UK, there is a notable increase in unsecured debt such as personal loans. The unsecured debt rose by 8.6% in March 2018 (Harari 2018). The increase in unsecured debt is because there are no strict regulations governing this debt. Lenders of unsecured debt have adopted tighter credit scoring criteria especially on granting the loans. This move has seen the level of unsecured debt drop from 10.9% growth recorded in November 2016 to 8.6% in March 2018 (Harari 2018). Lending policies of the lenders, therefore, influence the debt level of households. When the policies are relaxed, more individuals access loans thus increasing the level of debt. However, when lenders implement strict policies, only a few people can access the loans thus decreasing the level of household debt.

How financial crisis depends on debt

 Financial crisis is a condition where some financial assets rapidly lose a big part of their nominal value. Global financial crisis occurs because of reasons which may not be based in truthful information or obvious logic and parties to the financial contract conclude that the debts are not likely to be repaid. As a result, financial institutions such as banks stop issuing funds and request early payment of debts and other financial products. They clear up financial assets that can be sold and increase security needed to a level beyond prior expectations of market participants. The outcome of the situation is a frozen financial market where trading volumes are relatively low and households cannot be enticed to trade in financial instruments no matter what rates they are given (Karanikolos et al. 2013). In most cases, the high level of debt is backed with securities which are mainly properties. The property market is also one of the main debts that most households have. Loaning huge amounts of money into the property market increases the price of houses because of the forces of demand. When the price of houses is high, the volume of debt also goes up because individuals will require more money to purchase a house. Interest must be paid on all the loans that have been issued and with debt rising faster than incomes, in the long run, some households are not able to repay their loans. The consumers stop paying the loans and the banks find themselves at the danger of going bankrupt. A good example of the dependency of financial crisis is the 2008 global recession which originated in the United States as a result of high debt levels in mortgage markets.

Additionally, when household has debts weighing them down and with the cost of living increasing and wages not rising at the same rate, individuals are left with little money to spare for spending on consumer goods. Hence, they are unable to meet debt payments and end up defaulting on loans. When households minimize their expenditure, the economy slows which creates recession. The financial crisis of 2008 in the United States was started by high mortgage rates which made households unable to repay their loans and hence slowing down the economy. According to Deakin School of business Dr. Rashad Hasanov, a one percent increase in domestic credit has the likelihood of a banking crisis by 6% to 8% (Deakin University 2018). Government regulation is therefore needed to help reduce the effect of household debt on financial crisis. 

References

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