This week I would like to dedicate my post to a concept that many might have a misconception on. Locally, and especially with the older generation of clients, there is the conception that debt is bad and should be avoided – to be used only as a very last resort. Here I am talking about personal debt not business loans. What I would like to convey with this post is that debt is not evil and is one of the tools that, if used properly, can lead to improve one’s financial position.
Types of Debt
First of all let us go through the types of personal debt that exist. Not all debt is of the same nature and different debt instruments are used for different financing requirements.
Revolving Credit Facilities
Credit cards and overdrafts are two forms of debt that are normally the most expensive. They are referred to as a revolving credit facility since you can pay back part of it and get more credit to use. This form of debt is the most convenient type and is ideal for short term financing of small balances. Most common uses are shopping, on-line payments, car rentals, holiday expenses and the like. Most credit cards only charge an interest after a certain amount of days have elapsed and hence if used well can be a low cost method of getting temporary credit. If left unpaid credit card and overdraft expenses can rack up quite a bill, so as with any form of debt they must be used wisely.
This form of debt is more suited for medium term projects such as the purchase of a car, a loan for further studies or the purchase of a boat for example. Here we are looking at a term of 5-7 years and an expense of 5,000 to around €40,000 for example (amounts depend on the personal circumstances of each individual, the figures used are just indicative examples).
Things to keep in mind with this form of debt is that the shorter the maturity that one chooses, the higher the monthly repayments will be. So one must not automatically choose the shortest duration possible, but must also consider his/her affordability in good and in bad times.
Another thing to keep in mind with unsecured loans is that they are going to be more expensive than secured loans such as a home loan, since the bank granting you the loan is taking on more risk by granting it unsecured. So another thing that one might consider is, should I offer a form of security for my medium term loan in order to get a better rate? Forms of security can be money in the bank itself, money invested in other financial instruments or property. It might make sense to take out a (or use an existing) life insurance policy that would be tied to this particular loan. So just because it is offered unsecured, it does not mean that you have to take it as unsecured.
Of course one also needs to keep in mind the use of the funds. Just because the bank has offered me a €5,000 loan facility does not mean I should use it to go buy the latest UHD Television. Just because my neighbour went on a dream holiday it does not mean I should go take a loan to have an even better holiday. When I say that debt can be used to better one’s standard of living it still needs to be used responsibly.
Secured debt is basically any loan that has some form of security pledged against it. The most common form would be the home loan or mortgage whereby the bank will normally grant you a maximum of 90% (local custom) of the value of a property you intend to purchase. Most likely the bank would also require the borrower to take out and pledge some form of life insurance policy. This form of debt is normally offered at the cheapest rate since it presents less risk to the bank (within certain parameters).
However, even though in percentage terms it is the cheapest, in absolute terms it is still quite expensive since the amounts tend to be larger. The concept is easy to understand with two simple examples. Would you prefer paying 5% on €10,000 for 5 years, or would you prefer paying just 2%, but on €100,000 and for 35 years? The cost is even larger when you consider that interest is normally calculated on a daily basis and in the first years a larger amount of the monthly payment goes towards interest payment rather than capital repayment.
Risks of taking on too little debt.
We all know that a lot of debt is dangerous and biting off more than you can chew is a risky thing. But can one also be increasing risk by not taking on enough debt?
For the majority, it is inevitable that a home loan would be needed when buying a property. There are some who have the conception that taking out as small a loan as possible is the goal. In reality it definitely is not. Referring back to my description of the types of loan facilities available, a home loan is one of the cheapest forms of loan available. So if you are going to try to stretch your budget as far as possible in order to have as little a loan as possible you will likely end up being in a worse financial position than if you take out a larger loan.
One must keep in mind that investing/saving money is not done simply to make money quickly and cash out. One of the main goals is to make money and if it comes quickly, all the better. But investments also act as a form of buffer for the bad times. So a store of value if you will. Therefore, if you intend to use up all your savings and investment to buy one property and take the smallest home loan possible you are going to end up risking not having enough savings set aside for a rainy day. Besides the fact that mostly everyone who has ever bought a property for personal use ends up going over-budget with the finishes they choose. This means that you will need more money to complete the project.
It is a good thing to save up before buying a property in order to be able to take out a smaller loan. As a minimum you still need to pay around 10% of the property value and the taxes and expenses involved in purchasing a property. However one should not stretch his/her budget too thin that one has to end up sacrificing a better standard of living for a long time simply because they do not want the burden of more debt. This is not to say that one should borrow the maximum possible that the bank will lend them, The larger the loan, the higher the monthly payments and once interest rates increase the variable rate mortgages will have even higher monthly payments. So it is more about finding a balance between what one could comfortably afford in monthly payments and how much one needs to finance his project.
The Bottom Line
Debt in itself is not evil and should not be avoided at all costs. As with any other financial instrument it should be used wisely and it must be kept in mind that avoiding debt too much can be as risky as much as taking on too much debt. Using up all your savings and investments in order to buy a property is the same concept of selling all your current investments to buy just one investment. It is the opposite of diversification and leaves you exposed to not having enough money set aside for the bad times.