Debt financing and debt financing as well as self-financing are actually business terms that are used in the context of corporate financing. But that does not mean that they do not play a role in private business.
Like businesses, private consumers need to weigh up the advantages and disadvantages of different forms of finance before deciding on a particular type of financing.
This article is about the pros and cons of debt financing for private purposes. Every borrowing involves certain risks.
That is why the commonly given advice is to get by without credit.
But consumers are not always able to follow this advice, and there are cases where the benefits of borrowing outweigh the risks involved.
Before we turn to the question of when a loan financing is useful and when not, here's a short definition.
What does debt finance mean?
Credit financing is the time-limited supply of funds from the outside, to make investments or meet consumer needs.
According to business criteria, it is always a debt financing, which is provided by third parties.
In contrast, self-financing means the financing of projects with self-generated funds.
In the private sector, the "third parties" are regularly banks, private individuals or public institutions.
In business, funds may also come from other creditors, such as suppliers or customers.
The legal basis for the award of funds is a concluded loan agreement. At least the most important cornerstones of credit financing must be laid down in it:
The Contracting Parties, the amount of the loan plus interest (effective annual interest rate plus any other possible costs) and duration, any repayment modalities and, where appropriate, provisions on purpose.
Loan finance is differentiated not only by lenders but also by maturity:
Short-term loans: terms up to one year.
Medium-term loans: maturities up to four, sometimes five years.
Long-term loans: maturities longer than four or five years.
The differentiation by maturity 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.
Especially short-term loans are also expensive. Examples are disposition loans or framework loans that have virtually no agreed maturity. Reasons for the higher interest rates are higher refinancing costs and the uncertainty of profit expectations of the lenders.
From the point of view of borrowers, long-term debt poses the greatest risk. Changes in economic and / or personal circumstances (job loss, divorce) can lead to difficulties in repayment.
The Bundesbank regularly publishes statistics on average interest rates on loans to households, which reveal the risk assessment of lending.
For example, in October 2017, the effective annual interest rates for short-term loans were 6.06%, for medium-term loans up to five years 4.30% and for long-term loans over five years 6.81%.
Benefits of loan financing
Larger investments or purchases can seldom be financed with current income alone.
Example: In five years, a new car is needed, which should cost about 20,000 euros. For financing, 300 euros are covered monthly and regularly invested in call money. At the end then the necessary funds for the car procurement are available.
However, monthly payments of less than 300 euros are also available for subsistence or asset accumulation without the simultaneous existence of an asset.
The car is not financed simultaneously with the acquisition by credit, but prematurely with own funds. From a purely economic point of view, this is not necessarily sensible for large investments.
In most cases, it makes more sense to extend financing costs at least partially over the normal useful life of an investment. This can benefit from inflation losses.
Example: A term loan of EUR 100,000 will be taken out. The annual inflation rate is 2%. After the first year, the liability is only 98,000 euros "worth", solely due to the loss of inflation.
Loan financing also provides a high degree of flexibility. Even larger purchases or investments can not always be planned ahead.
If suddenly a new car is needed because the old vehicle is no longer repairable, the new acquisition can only be financed with the help of a loan if the required own funds are currently not available.
The prerequisite is that investments are financed by credit, which yield returns. This return must be higher than the cost of borrowing.
Example:
100,000 euros are invested in securities with a yield of 10%.
The return on equity is calculated as the sum of the interest income divided by the equity capital invested.
The return on equity is the rate of interest, namely 10%, if the securities are financed solely from their own resources.
The situation is different, provided that the securities are 50% equity and 50% debt. The annual interest rate for the borrowed funds should amount to 5%.
Also in this case, the mixed-financed securities generate 10% or 10,000 euros annually.
On the other hand, interest rates of 2,500 euros are incurred, which reduce earnings accordingly. The profit is now only 7,500 euros.
However, this lower income is generated with only half of the equity capital. The result is the following calculation:
7,500 euros / 50,000 euros = 15% return on equity.
In our example, the use of borrowed capital increased the return on equity from 10% to 15%.
The leverage effect is a secret of success among many of the security gurus Warren Buffett. The successful investor buys undervalued quality stocks partly on credit. He also takes out low-cost loans from one of his companies.
Of course, the leverage effect will only work if the returns on the loan-backed stock are higher in the longer term than the prime rate.
Warren Buffett has the knowledge and the tools to do just that. Private investors usually have neither one nor the other. Therefore, caution should be exercised when purchasing securities on credit.
Consumers are most likely to benefit from the leverage effect if they can afford to buy a property that promises lucrative rental income.
Risks of debt financing through loans
As with saving, the regular interest and principal payments tie up capital and limit liquidity. One can regard this circumstance as a disadvantage.
If additional collateral has to be provided in addition to a salary transfer, capital is also tied up.
Example: Securities holdings or endowment policies are given as a pledge. Borrowers can no longer freely dispose of their capital.
Another disadvantage is the cost, more precisely, the effective interest to be paid.
Interest charges can be minimized. Private individuals are able to do this primarily through real estate loans.
Examples: the use of residential cronies or the promotional measures of KfW Bank or the use of country-specific home subsidies.
Finally, earmarking can be a hindrance. If an earmarked loan is taken out, the borrower can no longer dispose of the loan amount freely. Sometimes, for example, for residential loans, even evidence of use must be provided.
Tips on loan financing
Limit borrowing to a minimum. Use own funds, unless you can earn money with debt financing.
Example: Borrowing is worthwhile if the returns on your investments are higher than the borrowing costs.
Avoid loans for consumer spending. Loans are used to leverage investments or acquisitions.
Choose a reasonable term. The term should be limited by the projected useful life of the debt financed item. The shorter the term, the cheaper the loan.
Pay attention not only to favorable interest rates, but also to flexible special conditions such as free special repayments or the possibility of free total repayment.
Do not enter into any additional agreements such as residual debt insurance or other financial products related to credit.