0455 · 3.2Households

Income, spending, saving and borrowing

0:00Imagine a family planning to replace an old refrigerator. They could buy it using this month’s income, save towards it, or borrow the money. Each choice connects what they can afford today with their finances tomorrow. By the end of this video, you will understand the influences on households’ spending, saving and borrowing. A household is a person or group of people living together who make economic decisions. Its income is money received over a period of time, such as wages, pensions and government benefits.

0:28Disposable income is what remains after direct taxes, like income tax, have been deducted. This is the amount a household can spend or save. Spending is expenditure on goods and services. Whatever part of disposable income is not spent counts as saving. Borrowing brings in money that must be repaid, usually with an extra payment called interest. The three choices are linked, because every dollar used one way cannot be used another.

0:53Saving some income now leaves less for immediate purchases, but builds funds for the future. A loan lets a household spend beyond its current income. Later, repayments reduce the money it has available. So borrowing moves purchasing power from the future into the present. Higher income allows households to increase both spending and saving in total. A family might buy better food and still put more money aside each month.

1:16Both rise because the amount available has grown. After a fall in income, paying for essentials can leave very little to save. Lower-income households usually spend a larger proportion of their income. Essentials such as food, housing and electricity absorb much of what they receive. Once those needs are covered, higher-income households have more room to save. So richer households spend more dollars in total, while poorer ones use a larger share of income for purchases.

1:43Income also affects borrowing, through two competing influences. A better-paid household may need fewer loans to cover everyday expenses. Lenders, on the other hand, will usually offer it more credit, because it can afford the repayments more easily. So higher income raises the ability to borrow. Whether the family actually borrows more is its own choice. A household with falling income might seek a loan to cover an unexpected bill.

2:07The difficulty is that its ability to repay has also weakened. A lender could refuse the application or offer a smaller amount. Needing to borrow and being able to obtain a loan are different things.

Interest rates and household choices

2:17The rate of interest is the cost of borrowing or the reward for saving, expressed as a percentage. A higher rate makes any new loan more expensive. Savers, meanwhile, earn a bigger return on each dollar in their accounts. So households save more and borrow less when interest rates rise. Spending falls through more than one route. Some families postpone purchases they planned to finance with loans. Those with a variable-rate loan, whose rate follows the market, face higher repayments on existing debt.

2:46And because saving now pays better, buying things today looks less attractive. Household expenditure therefore tends to fall. Consider a family with a variable-rate loan of three thousand dollars. Its annual rate of interest rises from four per cent to seven per cent. Assume the amount owed stays at three thousand dollars all year, with no fees. At four per cent, the interest is three thousand dollars multiplied by four, divided by one hundred.

3:11That gives one hundred and twenty dollars a year. After the rise, three thousand dollars times seven, divided by one hundred, gives two hundred and ten dollars. Subtracting the old one hundred and twenty dollars leaves an extra cost of ninety dollars a year. That ninety dollars is no longer available for purchases or saving. The family might cut entertainment spending or postpone buying new furniture. It could also decide against another loan, because new borrowing now costs more.

3:37A savings account paying a higher return becomes more attractive too. Yet with ninety dollars less to spare, this family may put aside less money, even though the incentive to save has grown. A cut in the rate of interest works the other way. Cheaper loans make a large purchase easier to afford, and postponing consumption earns a smaller reward. Households therefore tend to borrow more, save less and spend more.

Confidence, age and culture

4:01Income and expectations still shape each decision, so the response varies between families. A worker who expects secure employment and rising pay may happily buy a car with a loan. Her future earnings, she believes, will cover the repayments. Economists call this optimism about future jobs and income confidence. High confidence raises spending and borrowing, and households save a smaller part of their income. When confidence falls, households fear unemployment or lower earnings, so they delay non-essential purchases.

4:32Many build an emergency fund instead. Putting money aside for unexpected difficulties is called precautionary saving. However, a household whose income has already fallen may not be able to afford that reserve. Age matters because income and needs change during a person’s life. Young adults often earn relatively little but face large costs when setting up a home. Borrowing lets them buy furniture or housing before they have built up savings.

4:55They repay those loans later from higher income. By middle age, earnings are usually higher, so households save towards retirement or their children’s education. After retirement, many people live on a pension that is smaller than their old wage. They therefore draw on savings built up earlier in life. Dissaving means spending more than disposable income. The gap is paid for from past savings or by borrowing. These patterns are typical, not rules for every person.

5:23A careful young adult might save before making a major purchase, while someone in middle age could still be repaying a large housing loan. Some retired households with a generous pension even keep saving. Attitudes to money also vary between societies. Culture means the shared beliefs, values and customs of a society or community. Where debt is seen as shameful, households borrow less and save more. In other communities, borrowing for major purchases is widely accepted.

5:50Religious beliefs about interest can also affect which loans and savings accounts households choose. Customs also shape spending on celebrations, gifts and support for relatives. Environmental values can lead households to repair appliances instead of replacing them. This saves money and conserves scarce resources. So financial decisions reflect priorities as well as available money, and individuals within one community can still choose very differently.

Exam skills and interest-rate analysis

6:16Many exam answers mix up saving and savings. Saving is the flow of unspent income during a period, such as a month. Savings are the stock built up over many years, and dissaving runs that stock down. Remember too that higher income lets spending and saving rise together. Keep incentives separate from what a household can afford. A higher rate of interest encourages saving, yet larger loan payments can leave a borrower with less spare income.

6:42Payments on a fixed-rate loan stay the same until the fixed period ends. Only variable-rate borrowers pay more straight away. In a multiple-choice question, find the one influence that changes, such as the rate of interest or confidence. Then follow it through to borrowing, saving or spending, and choose the option that matches. In written answers, define asks for a precise meaning and state for clear terms, while explain sets out reasons why or how.

7:09Analyse goes further and examines the relationships in detail. Consider this question: discuss whether a rise in the rate of interest will reduce households’ spending. Discuss means writing about the issue in depth in a structured way, with both sides. Begin by connecting higher rates to borrowing costs and saving rewards. Then consider households whose circumstances could produce a different outcome. A rise in the rate of interest increases the cost of loans.

7:35Households therefore postpone purchases financed through borrowing. Borrowers with variable-rate loans face larger repayments, so they have less money for other goods and services. Saving also earns a higher reward, so households consume less now. Together, these effects reduce household spending. However, households with large savings receive more interest income and may spend some of it. Fixed-rate borrowers do not face higher payments straight away. Rising wages or strong confidence could also keep spending up.

8:03So the size of the effect varies with each household’s debts, savings and income. On balance, a higher rate of interest usually reduces household spending, because it discourages borrowing and rewards saving. The fall is likely to be largest where many households have variable-rate loans. Where wages are rising quickly, or savers hold large deposits, spending falls less. Households balance present needs against future opportunities and obligations. Income sets how much they can spend, save and borrow, while the rate of interest changes the rewards and costs of each choice.

8:36Confidence affects how willing they are to commit future earnings. Age and culture explain why one change can bring varied responses from different households.