The Importance of Debt Financing

Debt financing is a concept that involves borrowing of money that is intended to be repaid at a future date. The amount to be repaid includes the principal amount plus interest accrued over a specified period of time. In case of default, the amount can attract penalty at a specific rate over a period of time. Forms of debt financing to individuals include overdraft, credit cards, mortgages, hire purchase buying, and bank loans (Bernasek and Bajtelsmit, 2002). The importance of debt financing to individuals is that it’s a cheaper way of resuscitation from a financial crisis to enable one to cover essential services like food, shelter, and clothing. Moreover, raising debt is cheaper than raising capital for personal development. It is cheaper to raise debt than capital because of the tax implications associated with capital.

Debt financing is important in improving the long-term financial position of the company. The funds are used to make purchases and do investment projects that are important for personal growth. Hence, personal debt helps individuals to improve their individual financial obligations in payment of bills like school fees (Engen et al., 2005). For instance, students are helped to finance their education through personal loans which are repaid on completion of their education. Thus, debt financing helps in realizing the education needs of the students.

Also, in debt financing, individuals do not lose ownership of their properties. For example, individuals’ ownership of property cannot be rescinded because they own a loan to the government. A farmer may accrue a loan to the government in form of farming equipment and facilities to facilitate the production of goods and services (Bernasek and Bajtelsmit, 2002). Although the government will put pressure on the farmers to honor their obligations, the government will not take possession of the goods and services. Equally, the amount paid as debt is paid together with interest which is tax deductible and thus reducing the net obligation of the amount paid.

Another importance of debt financing is that it is secured with individual property and this forms part of secured loans. Individuals have to provide collateral for them to be advanced the loan. Such collaterals include title deeds, log book, and share ownership certificate in a publicly listed company. Personal debt can be given by a friend, company, bank or even a family member (Engen et al., 2005).

Why individuals take debt

Individuals take debt to fulfill their financial obligations. These obligations include farming needs, school fees, anniversary events, sickness, and even leisure. Depending on the individual social status in the society, the amount taken differs from one person to another. The debts are usually taken for short-term obligations to meet long-term gains (Brooks and Mukherjee, 2013). Some individuals just take debt as a means of exploring debt while a majority take it due to economic influences.

Advantages of debt

Maintaining ownership

The advantages are maintaining complete individual ownership without any interference. The only obligation is to repay the principal amount plus the agreed-upon interest within a specific period of time. The financial relationship ends when the full amount is repaid.

Retention of profits

The business is not obliged to share the profits with the lender but he is only required to remit the agreed amounts at a specific time frame.

Disadvantages of debt

Bankruptcy

Individuals who take loans run the risk of bankruptcy in case they default their loans. Worse still, if individual properties were attached as collaterals, their properties could be impounded by auctioneers. Thus, individuals should take loans which they are sure of repaying back.

Repayments

Macroeconomic times may be hard but individuals are still obliged to pay the loans. Thus, individuals must be sure to pay such loans even in hard economic times.

Credit rating

Failure by individuals to honor their financial obligations may hamper their chances of securing future loans due to poor rating. For instance, the emergency of unsecured mobile bank loan like branch has increased the uptake of credit facility. However, the high default rate has resulted in a number of people being listed in the credit reference bureau.

Accessibility

It is extremely hard for individuals who want to venture in a startup to access credit. It arises due to challenges associated with cash flow and long-term viability of the project. New ventures are considered risky by financial institutions.

What are the key economic influences in Debt?

Debt management skills

Debt management skills are important for the personal and economic growth of the country. Individual financial decisions dictate the dynamics of the nations. Appropriate financial literacy and sound measures in debt management play a role in financial matters of a country. Controlled debt financing ensures appropriate debt planning which entails planning of finances. Accordingly, controlled debt financing has long-term benefits to both the individuals and the state (Brooks and Mukherjee, 2013). For instance, most governments want its citizens to have affordable housing for its citizens. The worthy course can be achieved by taking mortgages from housing corporations and government incentives on the tax rebate for those who take mortgages.

Mortgages promote individual house ownership plan instead of renting. Although most people prefer renting, individuals who have invested in mortgages have reduced the housing problems especially in the later years which are unproductive. Moreover, taking up of loan for car enhances the mobility and productivity of the nation. It reduces the amount of time lost in public transport which translates to lost income. Owning a car means an improvement of the standards of living. The economic influence of mobility and an incentive to fueling by the company tremendously influences the uptake of car loans (Brooks and Mukherjee, 2013).

Another economic influence of debt is the credit card that is used to do personal shopping and fulfill the financial obligations at the end of the month. That fulfillment ensures that individuals are able to meet their daily needs instead of opting for shylocks who are too expensive. Credit cards provide platforms for accessing airtime, fueling, shopping for personal emoluments, and payment of other bills like electricity and water (Brooks and Mukherjee, 2013). In these instances, debt acts as a second income because it positively impacts on the economic standards of the country.

The economic influences of debt may bring negative impacts on the country especially when individuals misuse debt financing. Increased debt may result in problems especially to low-income earners. Debt reduces the disposable income to consume and thus reducing the purchasing power of individuals. The exposure to these vulnerabilities reduces the morale of low-income earners and subjecting them hard economic times (Benhabib and Bisin 2002). Some employees could significantly commit their pay slip to loans that exposes them to abject poverty which results in the poor working class.

Individuals from the age of 20-30 have high debt problems because of the high spending spree and lack of adequate financial knowledge. Also, the borrowing process is easier coupled with the need for youths to live large. Compounded with the high cost of debt, the problems persist due to low income. Controlled debt can be attained if only a few people decide to engage in debt (Zimmerer and Scarboroug, 2005). The situation is worse when a majority of low-income earners decide to use debt. Mostly, debt is attributed to poverty and job insecurity. Individuals’ belief that taking a loan from his employer increases chances of staying in the job for a long term. Unfortunately, that increases the debt burden and exposes them to exploitation by their employer. Similarly, the impact of inflation has an impact in the purchasing power because households have to buy few goods at a relatively high cost compared to periods before inflation. Income fluctuations also play a role as the income of individuals keeps reducing from time to time due to taking loans. Moreover, the principal amount has to be paid together with interest hence, debt planning is important because you have to pay more for the money that is to be repaid in the future.

Different kinds of debt financing and their differences

Secured loans

Secured loans are those that need a collateral to be taken up. Secured loans can be taken by individuals for purposes of obtaining funds for undertaking projects, incurring the unexpected expense, and doing repairs. They usually attract a favorable interest rate compared to unsecured loans. Hence, the loan is less risky to the financial institution because a security has been attached. In case the lender is a reputable bank, individuals’ are able to build creditworthiness. Specific types of secured loans include mortgages, personal secured loans, homes loans, and secured credit card (Brooks and Mukherjee, 2013).

The secured option is available to anyone who intends to borrow money because it has numerous benefits as compared to unsecured. In most cases, secured loans are easier to obtain because the lender has a security to attach to the loan and in case of default, the security can be auctioned. Also, the loan is less risky to the bank and the amount borrowed is likely to be higher (Benhabib and Bisin 2002). Similarly, secured loans can be repaid in a longer period of time because it is usually a large amount that is involved.

To qualify for a secured loan, you also need to have a good credit score apart from the securities provided. Moreover, an assessment is done to ensure that the principal amount plus the interest can be paid in full. It is prudent that the borrower understands all the information before filling an application form (Brooks and Mukherjee, 2013).

Unsecured loan

An unsecured loan is a form of the loan that an individual is provided with without tangible security. Hence, no personal property like house or car is attached to the loan meaning that you cannot lose your property in case the loan has defaulted. The catch for this loan is that they have a high-interest rate compared to secured loans (Brooks and Mukherjee, 2013). They also offer short-term financial solutions and the amount that can be borrowed is usually low. Examples of unsecured loans are unsecured personal loans and student loans.

Recently, unsecured mobile phone loans have emerged like branch international that provides loans. Small lenders are able to get unsecured loans. The loans are approved without a collateral. The only information required for this form of loan is income and the credit history of the borrower. Moreover, the lender cannot take the physical assets of the borrower in case the borrower stops repaying the loan. The only thing that is needed before the loan is awarded is an agreement that contains the promise to repay the loan (Brooks and Mukherjee, 2013). The credit score for unsecured loans is looked at by checking at the credit report on the loan history of the borrower. For income, the lender acquires the information from bank statements, tax returns, and pay slip of the lender as a proof of income and ability to repay.

How individuals can take advantage of debt financing

Individuals can take advantage of debt financing by obtaining cheap loans to open up small business enterprises. The main source of funds for small businesses is debt financing. Although small businesses are allowed to issue bonds, they lack the financial muscle and stringent regulations. Similarly, small lenders can prove that they have the financial capability of repaying their loan and maintain the cash flow of the business (Brooks and Mukherjee, 2013). In that regard, credit offers to keep on increasing because of sufficiency in credit repayment. Therefore, individuals can take advantage of debt financing to stimulate their small businesses, improve their credit score, and enable individuals to cover future cash crunches like through mortgage financing.

Key differences between secured and unsecured loans

The key differences between secured and unsecured loans are that for secured loans, an individual has to provide a collateral like a title deed, and a log book as a surety. Whereas an unsecured loan is a loan advanced without a security thus, the lender has to have the credit score of the consumer as well as his income (Brooks and Mukherjee, 2013). Similarly, secured loans advance long-term loans at a relatively low-interest rate while unsecured loans provide short-term loans at a relatively high-interest rate.

How financial crisis during 2007- 2009 depending on the debt?

How financial crisis impact on the overall economy

The financial crisis of impacted negatively on the economy because of the recession. Overall, the rate of unemployment became high which resulted in the increase of arrears in housing and school. Consequently, there was a significant reduction in spending in housing that was attributed to lower disposable income among households (Hurd and Rohwedder, 2010). The investors were pessimistic on stock prices. Overall, individuals were pessimistic of the future because of the prevailing economic situation. The wealth of the people significantly reduced and the value of assets fell. The wealth holding showed a declining exposure on the individual holding in wealth.

Further, the long-term living standards of the people are affected due to the high risk that is associated with wealth losses. Particularly, the portfolio of older individuals is largely affected because of the reduction in resources they could have generously used in there sunset years. For younger generations aged between 20-30 years, they need to save more in comparison to their income. There were changes in consumption levels and wealth changes among individuals (Hurd and Rohwedder, 2010). The households revised their expenditure to cope up with the crisis and safeguard themselves from financial shocks that are attributed to the crisis. The effects of the crisis from the data available indicate that most of the effects of the financial crisis arise from national price indices and the pre-crisis wealth holding. The value of the amount held as pension reduced significantly. Stock market stimulation resulted in the decline of the stoke market by 40%.

Impact on individual borrowing

There was a reduced number of borrowers during this period because individuals were hard hit by the crisis. New lending fell significantly relative to other periods when credit uptake was fairly high. However, individuals’ were in high need of cash that was to fulfill short-term obligations. Banks at the same time cut their lending because of inaccessibility to deposit and thus the credit line was too hard to be met by the households (Hurd and Rohwedder, 2010). Hence, the cost of borrowing rose to make it hard to access credit. The banking panic resulted in the restructuring of the panic rules regarding uptake of credit. During the peak of the recession, lending reduced up to 77% compared to the previous period. There was a general change in lending policy and the default rate rose during the period.

Challenges of households during the financial crisis

Financial crisis brings changes on family dynamics on spending especially on the approach on who makes the financial decisions on spending. Families have to brave for hard economic times because they are subjected to a limitation in spending even on essential goods and services like food, shelter, and clothing. Moreover, the issue of self-control arises because of the psychological influence of the crisis (Hurd and Rohwedder, 2010). Thus, households have to choose between consumption and saving. Similarly, health crisis may arise due to lack of funds thus the arrangement of households portfolios towards health are limited. Despite a strong connection in financial status and health, individuals with health problems suffer more and their financial obligations cannot be met. Another challenge is the cognitive factor that revolves around financial soundness of households. Due to families’ weak cognitive ability, they were hit hard by the crisis due to poor economic choices.

References

Benhabib, J., and Bisin, A., 2002. The Psychology of Self-Control and Consumption Saving Decisions: Cognitive Perspectives

Bernasek, A., and Bajtelsmit, V. L., 2002. Predictors Of Women‘s Involvement In Household Financial Decision-Making. Financial Counseling and Planning, 13(2), 39–48.

Brooks, R. and Mukherjee, A.K., 2013. Financial management: core concepts. Pearson.

Engen, Eric M., William G. Gale, and Cori E. Uccello, 2005. “Effects of Stock Market Fluctuations on the Adequacy of Retirement Wealth Accumulation,” Review of Income and Wealth, vol. 51, no. 3, pp. 397-418.

Hurd, M. and Rohwedder, S., 2010, ”Effects of the Financial Crisis and Great Recession on American Households”, National Bureau of Economic Research, Working Paper 16407

Zimmerer, T.W. and Scarboroug, N.M., 2005. Essentials of entrepreneurship and small business management. Prentice-Hall.