Lesson preview · Budgeting and borrowing
Budgeting, borrowing and protecting your money
~8 min · Free to read
A car dealer offers you a 5,000-dollar loan for a used car. You can repay it over 1 year at 444 dollars a month, or over 5 years at just 111 dollars a month. The second offer sounds far cheaper. In fact, it costs you about 1,340 dollars more.
Key Term
Interest, the term and the yearly rate
Interest is the price of borrowing: you repay more than you borrowed. The term is how long you take to repay.
Many loans also charge fees, such as a set-up fee. In many countries, lenders often have to show one yearly rate that counts the interest and most compulsory fees together. That lets you compare offers fairly.
Its name depends on where you live. In the United States and the United Kingdom it’s the APR (annual percentage rate), though UK mortgages show the APRC (annual percentage rate of charge). European Union rules call it the annual percentage rate of charge, shortened to APR or APRC. In Australia it’s the comparison rate, and “APR” there means the interest rate alone.
This rate usually leaves out charges you pay only if something goes wrong, such as a late fee.
Worked Example
You borrow 5,000 dollars, with no fees. The interest is 1% a month (quoted as 12% a year) on whatever you still owe, and you repay in equal monthly payments. Compare repaying over 1, 3 and 5 years.
So the monthly payment tells you whether a loan fits your budget. It doesn’t tell you what the loan costs. For the same amount over the same time, compare the total repaid. For offers of different lengths, compare the yearly rate that includes fees.
Trap · Common Misconception
"The lowest monthly payment is the cheapest loan"
A low payment often just means a longer term. You pay less each month, but for more months, so you pay more interest overall. Stretching the 5,000-dollar loan from 1 year to 5 cut the payment by about 333 dollars a month, but added about 1,340 dollars of interest.
Trap · Warning
Buy now, pay later and payday loans
Buy now, pay later splits a purchase into a few payments, often four, usually with no interest. Miss one and there’s often a late fee, and it’s easy to stack up several plans.
A payday loan is a small loan you repay in one go, usually on your next payday. The fee looks small, but it covers only a few weeks, so the yearly rate is huge.
Key Term
Gross pay and net pay
Gross pay is everything you earn before anything is taken off. Net pay, or take-home pay, is what reaches your bank account.
The gap is the deductions. They are usually income tax and compulsory contributions, such as payments into a state pension or health scheme. You can also agree to have money taken off, for example to pay into a workplace pension. The rules differ from country to country.
Build your budget on net pay, because that is the money you can actually spend.
A budget is a plan for your take-home pay. Split your costs in two. Fixed costs stay the same each month, like rent or a phone plan. Variable costs change from month to month, like food or going out. Fixed costs are hard to cut quickly, so variable costs are usually where you can save.
A popular rule of thumb, 50/30/20, splits take-home pay three ways. Half goes on needs (rent, food, bills), 30% on wants (going out, extras) and 20% on saving. It’s a starting point, not a law. Where rent is high, needs can take far more than half.
Tip
Build an emergency fund first
An emergency fund is savings kept for surprises: a broken phone, a dentist’s bill, a lost job. Money guides often suggest three to six months of living costs. Some count only the costs you can’t easily cut, such as rent, bills and food. Start small. Even a few hundred dollars can stop a surprise bill from pushing you into an expensive loan.
Worked Example
Sam is 19. He works part-time and shares a flat with two friends. His payslip shows gross pay of 1,800 dollars a month, income tax of 150 dollars and a compulsory contribution of 90 dollars. Each month he spends 650 dollars on his share of the rent, 30 dollars on his phone plan and 70 dollars on a bus pass. He also spends 300 dollars on food, 50 dollars on his share of the electricity bill and 210 dollars on going out and extras. Build his budget. How long will it take him to save an emergency fund that covers three months of his needs?
Key Term
Insurance and diversification
Risk means not knowing for sure how things will turn out. Your phone might break this year, or it might not. Insurance shares the cost when things go wrong. Many people each pay a small regular amount, a premium, into a pool, and the pool pays for the losses of the unlucky few.
Insurance doesn’t stop your phone from breaking. You swap the chance of a big bill for a small, certain premium. The risk doesn’t vanish: the pool carries it.
Diversification means spreading your savings across many different investments. Then one failure can’t wipe you out, and your savings swing up and down less. It reduces risk but can’t remove it: sometimes most investments fall at once.
Check yourself · no marks
A payday lender charges 15 dollars to lend you 100 dollars for two weeks. Roughly what yearly rate is that?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Check yourself · no marks
An insurer charges 60 dollars a year to cover a phone, and pays 1,000 dollars if it breaks. How can it afford to pay out so much more than you paid in?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 5
Mia’s payslip for March shows gross pay of 1,200 dollars, income tax of 96 dollars and a compulsory contribution of 60 dollars. What is her net pay, the amount that reaches her bank account?
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