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5 The borrowing process

5 The borrowing process

In the example in Section 4, the Syme family fell into debt due to some unexpected
circumstances. This section uses an example of someone deciding to take out a debt in
order to work through the issues involved in borrowing money.

5.1 How to finance a purchase

Let’s look at the example of Philip, who wants to purchase a music system costing £1000.
(We’ll assume that Philip cannot simply fund it out of his monthly budget.) In order to
finance the purchase, options would include:

1. using existing savings
2. building up savings first, and purchasing the item later
3. using a mixture of savings and debt
4. taking out a debt of £1000.

Figure 10 Philip wants a new music system
Which option is chosen will obviously depend on a number of factors including, crucially,
Philip’s initial financial position. Let’s start by running through some generic issues related
to each of these options.
The first option involves using existing assets held in the form of savings. If Philip has built
up savings, he could draw upon these to fund the music system purchase. In coming to a
decision on whether to use savings, he may think about opportunity cost – the savings
used to buy the music system will not then be available for him to purchase something
else. He will also be giving up the future income, in the form of interest earned, on the
savings that will be spent on the item. He might also compare debt costs with the loss of
income on savings. Generally, you’d expect the cost of debt, in terms of the interest that
will be paid, to be rather higher than income from savings for two reasons. First, savings
products and debt products are provided by the same institutions – such as banks and
building societies – and these institutions make their profits from the difference between
them. It is likely, therefore, that in normal circumstances the interest rate for debt will be
higher than the rate earned on savings. Second, interest on savings will be taxed as
income unless there is a means of sheltering the earnings – for example, by saving in tax-

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