Written by Preet Banerjee
Monday, March 26th, 2018
Not all large purchases are created equally. From a personal finance perspective, buying something that goes up in value over time, commonly referred to as an appreciating asset, is generally good. Buying something that loses value over time, known as a depreciating asset, is not so good, but sometimes necessary.
Different Types of Funding
There are two broad categories for the sources of funds to pay for your expenses: money you already have, and money you don't have. Money you don't have is just another way of saying "money you'll borrow."
Here are the different ways to borrow money for a large purchase.
Secured vs. Unsecured Debt
Broadly speaking, we have secured debt and unsecured debt.
Secured debt essentially means that whatever money you're borrowing is specifically backed by something of value that you might risk losing if you don't make good on your debt. Two prime examples: mortgages and car loans.
Unsecured debt, like credit card debt, is not secured by assets. Since that increases the risk of the lender not getting their money back if you stop making your payments, interest rates on unsecured debt are higher than they are for secured debt.
Installment Loans vs. Revolving Credit
There's also a difference between installment loans and revolving credit.
An installment loan has an end in sight: you borrow an original amount and then make your regular installment payments over a fixed period of time. Your auto-loan might last six years, for example. Your mortgage might have an amortization of 25 years.
Revolving credit is a moving target. You can borrow and re-borrow more later. Your minimum payment required might be quite low, covering only the interest (in which case you would never pay down your debt), or just a little bit more (which leads to credit card statements with absurdly long repayment predictions of decades in extreme cases).
Lines of Credit
Lines of credit come in both secured and unsecured form.
The most popular secured lines of credit are home equity lines of credit, where the money you borrow is backed by the equity you have in your home. Many people use a home equity line of credit to finance home renovations. A word of caution: it's easy to overestimate the value of home renovations and use that to justify large amounts of financing. Similar to getting a mortgage, it's important to make sure you don't overextend yourself. While a mortgage is installment debt with a known end in sight for payments, using a line of credit (which is a revolving form of debt) makes it easy to procrastinate paying down the principal.
Younger Canadians may have been offered student lines of credit, which are unsecured. After graduation, these student lines of credit are often converted into personal lines of credit (but they look and operate the same). Unsecured student lines of credit and unsecured personal lines of credit will generally have higher interest rates than secured lines of credit (like a home equity line of credit).
While credit cards are used more for frequent purchases (eating out, travel) and the odd large purchase, lines of credit tend to be used mostly for larger transactions.
They're also often used to reduce the cost of higher interest rate debt. For example, people carrying thousands of dollars in debt on credit cards might transfer these balances to a line of credit to reduce the interest rate on that debt.
The problem is, unless you fix your spending problem, you might end up with line of credit debt in addition to new credit card debt down the road. People also use lines of credit for home renovations, purchasing expensive toys (like snowmobiles or motorcycles), and more.
What we've looked at should help give some food for thought about the different types of large purchases and how to pay for them.
I want to emphasize that this is a framework to give you perspective, not necessarily a set of concrete rules. As they say, personal finance is personal. We all have different goals and circumstances, but taking a 30,000 foot perspective on large purchases in general can be an important input into our financial decision making process.