Wednesday, September 30, 2009

Using the right type of loan for your spending needs

In a perfect world, you would save up the entire amount before you buy the item, buy the item on your credit card and then pay the credit card balance off before interest is incurred. So basically by your superb account management, you've picked up reward/frequent flyer points which translates to goods and holidays for free (excluding the annual credit card fee that you pay of course).

Unfortunately however, this does not work for many people because they don’t save up the amount before they rush off to buy on the credit card. So when the bills arrive, they scramble around trying to find the money to pay the bills because their income isn't sufficient to pay everything by the due date.

The most important thing I can ever write about how to utilize loans is to match the loan type to your needs. If it’s a long term need, don’t match it with a short term loan or else you’ll be penalized by paying higher interest than you would normally be paying if you had organized the correct loan type in the beginning.

Companies know this. They don’t use a credit card or overdraft to buy a company car, they use leases and car loan financing. They don’t use a credit card or overdraft to fund office renovations. They analyse whether they can afford to buy goods upfront. If they can’t and they really need to buy the goods, then they analyse what type of financing they need, find the best loan type and deal (financing) and then they go and buy the goods.

Most consumers lack this critical research and analysis stage. They want something and they go buy it immediately.

Ordinary folks get into all types of difficulties because of this lack of awareness. If you have no choice but to buy an item that you can’t pay off before the interest free period ends then you shouldn’t be using a credit card. You’re better off using a longer term loan such as a Personal Loan or a Line of Credit to fund your purchase.

DO NOT use a credit card to pay for it. DO NOT use a payday loan to pay for it. In other words, do not use short term loans to buy something that you can’t pay off in the short term. That will be the best advice you ever need regarding loans.

1 comment:

  1. Spot on.

    Another thing. Companies uses leases for things like cars and computers for another slightly more complex reason:

    Use the desktop PC as an example. Buying the bog standard office PC costs about $2K give or take a bit.

    Pay that money up front - thats $2K gone out the door. Bad for cash flow.

    After 2-3 years the PC is technically obsolete and needs to be replaced. So during the 2 or 3 years the company had to set aside depreciation - money used at the end of the items life in order to buy another.

    Lets assume a 2 year replacement cycle. So about $1000 had to be set aside, each year.

    During the 2 year period - the cost then is $2K up front, and $1K each year after.

    In the 3rd year the depreciation money already set aside is used to buy another, and the cycle then repeats.

    The money which went out the door up front is capital expenditure, which is tax deductible because its a cost of doing business. The depreciation is a tax deduction as well because its a cost of keeping on doing business.

    Thats all fair enough but the impact on year 1 cash flow is you had $$3K go out the door, and $1K in the next year. The cash flow hit is bad.

    Then you have to get rid of the obsolete PC, and pay for repairs, and so on. So a maintenance contract is a good idea. More $.

    Leasing makes all this accounting stuff easy, which is its big attraction. The cost will be spread as well, and the lease normally includes things like repairs and maintenance.

    So I might pay for example $1500/year every year, and every 2nd year a new PC just turns up and the old one goes away.

    Companies like this - the accounting is easier, the up-front cash flow hit is smaller (even if they pay more actual $ in the long run), the depreciation account goes away, the item is maintained, and the obsolete ones become someone elses problem!

    During the 2-