Loan financing for private purposes
Credit and debt financing, as well as self-financing, are actually business terms that are used in the context of corporate finance. But that does not mean that they do not play a role in private business transactions. Just like companies, private consumers have to weigh up the advantages and disadvantages of the various forms of financing before deciding on a particular type of financing.
This article is about the pros and cons of personal loan financing. Every loan involves certain risks. Therefore, the advice given is to get by without loans if possible.
However, consumers may not follow this advice in all cases, and there are cases where the benefits of borrowing outweigh the associated risks. Before we turn to the question of when loan financing makes sense and when not, here is a brief definition.
What does credit financing mean?
Credit financing is the temporary supply of funds from outside in order to make investments or fulfill consumer wishes.
According to business criteria, it is always external financing that is made available by third parties.
In contrast, self-financing means the financing of projects with self-generated funds.
In the private sector, the “third parties” are regular banks, private individuals or public law institutions.
In the business field, the funds can also come from other creditors such as suppliers or customers.
A legal loan contract forms the legal basis for lending. At least the most important key points of credit financing must be set out in it:
The contracting parties, the amount of the loan plus interest (effective annual interest rate plus possible additional costs) and term, all repayment modalities and, if applicable, provisions on purpose limitation.
Loan financing is not only differentiated according to the lender but also according to the term:
Short-term loans: maturities up to one year.
Medium-term loans: terms of up to four, sometimes five years.
Long-term loans: terms longer than four or five years.
The differentiation between terms is important for both borrowers and lenders.
If the term is long, the risk of default increases. Lenders can pay the higher default risk with higher interest rates. Long-term loans are therefore often relatively expensive.
Short-term loans are also particularly expensive. Examples are overdrafts or framework loans that have practically no agreed term. The reasons for the higher interest rates are higher refinancing costs and the lenders’ uncertain earnings expectations.
From the perspective of the borrower, long-term liabilities represent the greatest risk. Changes in the economic and / or personal situation (job loss, divorce) can lead to difficulties in repayment.
Advantages of loan financing
Larger investments or acquisitions can rarely be financed solely with current income. If you want to forego loan financing, you first have to save capital.
In addition to the fact that large investments such as a property cannot be financed in the foreseeable future, capital is tied up and liquidity is withdrawn in the savings phase without a counter value already being available.
Example: In five years a new car will be needed, which should cost about 20,000 dollars. 300 dollars per month are deposited for financing and regularly invested in overnight money. In the end, the necessary funds for car procurement are then available.
However, 300 dollars less per month are available for subsistence or for wealth accumulation without an asset being available at the same time.
The car is not financed at the same time as the purchase, but rather prematurely with own funds. From a purely economic perspective, this is not necessarily sensible for large investments.
It usually makes more sense to at least partially extend financing costs over the normal useful life of an investment. In this way, inflation losses can be benefited.
Example: A final loan of USD 100,000 is taken out. The annual inflation rate is 2%. After the first year, the liability is only “worth” 98,000 dollars, simply due to the loss of inflation.
Loan financing also gives a high degree of flexibility
Even larger purchases or investments cannot always be planned in advance. If a new car is suddenly needed because the old vehicle can no longer be repaired, the new purchase can only be financed with a loan if the required capital is currently not available.
Another advantage is the leverage effect of debt financing. This describes the leverage effect of debt capital on return on equity. In other words, the use of debt as a substitute for equity can increase the return on equity.
The leverage effect is primarily interesting for companies and for professional investors in financial products. In principle, however, it can of course also benefit private borrowers or capital investors.
The prerequisite is that investments are financed by loans that generate returns. This return must be higher than the borrowing costs.
100,000 dollars are invested in securities with an interest rate of 10%.
The return on equity is calculated by dividing the total interest income by the invested equity.
The return on equity corresponds to the interest rate, namely 10% if the securities are financed solely from own funds.
The situation is different if 50% of the securities are purchased with own funds and 50% with external funds. The effective annual interest rate for external funds should be 5%.
In this case, too, the mix-financed securities generate 10% or 10,000 dollars annually.
On the other hand, interest on debt of USD 2,500 is incurred, which reduces earnings accordingly. The profit is now only 7,500 dollars.
However, this lower return is generated with only half of the equity. The calculation is as follows:
7,500 dollars / 50,000 dollars = 15% return on equity.
In our example, the use of outside capital increased the return on equity from 10% to 15%.
The leverage effect is a secret of success among many of the securities Good Credit. The successful investor partially purchases undervalued quality shares on credit. To do this, he takes out low-cost loans from one of his companies.
Of course, the leverage effect only works if the returns on the shares financed by loans are higher than the interest on the debt in the long term.
Good Credit has the knowledge and the tools to do just that. As a rule, private investors have neither one nor the other. Therefore, great caution should be exercised when buying securities on credit.
Consumers are most likely to benefit from the leverage effect if they can buy a property cheaply that promises lucrative rental income.