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Reasons for personal financing

By Katie Martin,2014-06-29 10:26
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Reasons for personal financing ...

Reasons for personal financing

    At each stage of our lives, there are reasons to consider our personal finances. Various forms of personal finance are available to fulfill the financial needs of people at the various stages of their lives, each with different terms and conditions. These terms and conditions influence the cost of finance to each individual. Comparing these provides information on which is the best choice for meeting the needs of each person’s unique circumstances.

Personal financing is the ability of an individual to provide funds in order to achieve

    personal goals.

    The reasons people require finance range from the simple need to survive, to the long-term goal of providing for retirement. To meet personal needs, finances can be categorised into six main areas, shown in:

    Each of these items will need to be considered when preparing a personal budget.

Survival

    Survival is the need for food, water and shelter in order to stay alive. In our developed society, these essentials are usually purchased from traders. This implies we need money, either from earnings or gifts, to finance these acquisitions. In third-world countries, most people spend all their energy on this aspect of personal financing. Many of them operate within a barter system.

Health

    Health is a major issue because the population in developed countries is ageing. It is essential to take care of one’s health to ensure quality of life. Therefore there is a need to

    consider preventative health measures. These may be as simple as keeping fit, or be a serious measure such as surgery. In Australia, Medicare is a compulsory insurance cover for health, funded through the tax system. There are also many private health-insurance schemes available for specialist and private hospital cover.

Education

    Education, in the form of life-long learning, is essential in our ever-changing society. It may take many forms, from learning about hobby interests to completing tertiary education courses. Therefore, education is one component that needs financing by each individual throughout their lifetime.

Purchase of major assets

    The most common types of assets individuals purchase are cars, houses, computers and electronic equipment (such as DVD players). These vary considerably in price and durability, ranging from very expensive but long-lasting (such as houses), to less expensive assets with a relatively short life span (such as computers).

Leisure activities

    Leisure activities are many and varied. Individuals may spend their leisure time on travel, the arts, volunteer work and/or sports, either as participants or spectators. The finances required for each of these activities vary depending on the extent of the participation, time involved and equipment needed.

Wealth creation

    Wealth creation is the process whereby individuals save some of their earnings for future needs. These savings are then invested in financial institutions, shares or property (to name a few) where they earn interest, dividends or rent, or create capital gain. Income gained via knowledge can also give an individual an opportunity to earn additional wealth. For example, a person may have knowledge about the share market that allows them to instigate profitable investment strategies.

Main forms of personal financing

    There are many forms of personal finance. The main types fall into two categories, self-financing and credit financing.

Self-financing

    Savings

    Savings are delayed spending by individuals. Savings can be invested to earn interest, thereby creating 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 many providers of credit card facilities, and they vary in the interest-free period available and the fees charged to have this facility. From 1 January 2003, merchants acquired the right to charge the customer a fee when accepting payment by credit card. A media release from the Australian Securities and Investments Commission about credit card fees is shown in:

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

    Loans can take many forms. The most common types for individuals are:

    • mortgages • equity loans

    • personal loans • investment loans.

Mortgages

    Mortgages are loans secured by assets, usually a house or property. Due to a very

    competitive market, there is a wide range of housing loan products secured by mortgages.

Fixed-rate loans are loans in which the interest rate does not vary for a number of years.

    After that period, the rate may be automatically renewed at the same rate, be converted to

    a variable rate or set at another fixed rate for another set period. Changes to this type of

    loan often incur charges by the bank, and this cost must be factored into any actual

    benefit from a change of loan type.

Variable-rate loans are loans in which the interest rate varies with market forces. This

    is the most common form of home loan.

    Low-start loans have a low rate of interest in the early years of the loan as an enticement to borrowers. After the initial period, they move to a variable rate.

    Interest-only loans are loans in which only interest is paid throughout the life of the loan. The full amount borrowed (the principal) is paid only at the end of the term of the

    loan.

Personal loans

    Personal loans are borrowings from a bank, financial institution or other source. This type

    of financing allows the individual to enjoy a service or the use of an item purchased while

    repaying the loan in regular installments. It allows the borrower to enjoy the pleasure of

    the purchase while paying for it. Personal loans are often used to finance holidays or

    dental and medical procedures.

Equity loans

    Equity loans are borrowings against the equity a person has, usually in a house or some

    other property. Equity is the term used to express the value of the assets one owns.

Investment loans

An investment loan is generally a loan for investment purposes such as rental property,

    share portfolios, stocks and/or bonds. This type of loan is usually an interest-only loan.

    The principal is not reduced, so the interest payments made on the full amount of the loan

    can be written off as an expense in earning the amount procured by the investment.

    Usually, this type of loan is low-cost and can be a tax effective way to invest. The most

    common types of investments have been set out in the following:

All of these types of loans carry some level of benefits and associated risk. When the

    market conditions are favourable, the risk is low, but the risk rises when the market is

    falling. The Table below compares the reasons for borrowing to invest with methods of

    managing risk.

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.

Review questions:

a Why is personal finance a necessity for each person?

b What are the main types of finance available to each individual?

c When would a mortgage be an appropriate type of loan?

d What is the difference between leasing and taking out a hire purchase agreement?

e When would an equity loan be available to a borrower?

f Access the loan calculator (http://www.national.com.au/Calculators/0,,51273,00.html)

    from National Australia Bank the Internet.

    ? How mcuh can you borrow if you earn $50,000- per year.

    ? By how much does that amount change if you have 1, 2 or 3 dependants

    (children)?

    ? Find the amount of repayments if you borrowed $10500 at an interest rate of

    6.25% to borrow a car.

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