Personal Debt – Should it be Avoided?


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.

Unsecured Loans

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

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.


Buy to Let, a Bubble in the making?


With historically low interest rates the attractiveness of the property market, and more specifically the “Buy to Let” sector has increased significantly, and this for a number of reasons:

  • Low interest rates means low yielding alternative fixed income investments such as bonds and the various types of bank accounts;
  • Low interest rates means that it is cheaper to finance the purchase of the property through a bank loan (even though technically these should be considered as business loans rather than home loans);
  • There seems to be no form of regulation on the property market with estate agencies advertising buy-to-let rates as investment products, without any form of warnings;
  • The inherent historical obsession of the local investor with the property market and the attitude that “land always appreciates” – I guess they have not heard of the 2007/09 financial crisis in which the property market was the key source of all the turmoil?!
  • The influx of foreign workers who re-locate to Malta as the demand for certain jobs that might not be fully catered for by the local work force has increased significantly. Such workers would typically be specialised IT developers who would more likely be looking to rent, at least in the first few years.
  • The increase in marital separations and divorce has also led to a demand for rental properties as proceedings can take a while to be concluded and it would involve some form of division of assets that would make it more affordable to rent a property as opposed to buying one.


What are the risks?

Although buying a property for rental income is not a bad thing in itself, there still are risks involved in such an investment. First of all, I am always sceptical of “investments” that are not regulated. Since property investing does not fall under the definition of a financial instrument it is not regulated by the very investor-centric regulations that financial instruments are. What this means is that as an investor you are not protected and the person selling the property to you has no obligation to explain the risks involved in investing into the property market. He/she doesn’t even need to know about the risks

Another risk of buying to let is that property investing typically takes up a large portion of one’s portfolio of assets. We all know how the advice is always to spread your risk by diversifying into different investments. If a person has for example €150,000 invested into a property for rental purposes and then has €20,000 in other investments, such an investor has a high concentration risk whereby 88% of his investments are in one single investment. In the same logic that one should never buy into one single investment when considering financial instruments, one should not have such a high concentration into property.

By its very nature, property is an illiquid asset, meaning it cannot easily be converted into cash. Even if one is lucky and manages to sell his property in say 3 months, there typically will only be a promise of sale first and then 6 months to a year later the contract will be done which could be subject to other things such as development approval, approval of a bank loan and so forth. If on the other hand an investor has a Malta Government Stock (MGS) and wants to sell €1mln in one day he will get his money in 3 working days.

The hidden costs are also a major factor to keep in mind. Since property as an investment is not regulated there is no obligation to mention all the costs from beforehand:

  • The initial costs in buying a property are typically a commission if a property dealer is used (not an agency, those are normally paid by the seller). There is then a tax to be paid on purchase of a  property. There are the notary fees to be paid for research and drafting of the contract. There are then the bank fees if a loan is being taken out to finance the project.
  • The on going costs – if an agency is going to be used in order to find tenants (which is the most convenient option), then the agency would take its commission for doing its work. If you are renting out a furnished property which is typically the case you not only need insurance on the property but also insurance on the content (furniture, fixtures and fittings). If your property is an apartment part of a block you also have the annual maintenance fee to be paid (for maintenance and upkeep of the common areas). There is of course the ongoing typical maintenance costs involved in keeping any property in good form such as painting and plastering from time to time and so on.

So when you add all the costs together you quickly realise that the advertised 4-6% rental income is just a gross figure and not the real net return. This is besides the fact that like other investment income the income from renting is subject to 15% withholding tax as well.

Another risk is the interest rate risk that exists. Here we have two factors in play.

  1. One factor is the current cheap  mortgages attributable to the current low interest rates. Some “investors” who are buying property with the aim or renting it out are not factoring in the event that interest rates could start rising and with them the cost of maintaining their bank loan. As interest rates rise the monthly payment needed to pay the mortgage on the property goes up and it might very well go up to the point were many would not consider it viable to keep renting out the property. In such a situation there will be a rush to sell properties. 
  2. The other factor is when you consider the income of renting out a property (with all the hassle that brings along with it) compared to the income from a regular bond or bank deposit.  As interest rates start to rise the difference starts to narrow and could even end up reversed whereby one could get a better interest on financial instruments as opposed to rental income. This scenario would also lead to a rush to sell property and hence a fall in the price of such property.

A final risk to consider is the dependence on foreign occupants for certain sectors of the rental market. Many rental properties around the Sliema, St. Julians, Gzira and Ta’ Xbiex area are occupied by foreigners form the IT, Gaming or Financial Services sectors. These tend to be employed by foreign companies that have been attracted to Malta mainly for the advantageous tax setup for non-resident shareholders. Imagine what would happen if the EU had to pressure Malta to change such tax setups and a number of these foreign companies had to relocate elsewhere!


Are we witnessing a bubble in the making?

When you have a situation that a lot of investors are switching to buying property in order to rent them, you quickly start to build up more supply of rental properties. This, coupled with all the reasons listed above as to why the demand for buy-to-let is going up, could end up creating a situation where property values go up in value too high, too fast. At the end, you end up with a situation where prices have to be corrected and you have a fall in the asset value.

Although I do not think that we have entered this phase yet, history teaches us that we are slowly heading in this direction. I am not talking about 20 years ago history, I am talking about a few years ago when there was a big drive for many people to knock down their house and build a number of apartments. All of a sudden ever Tom Dick and Harry became a contractor – at first it was quite a lucrative venture, eventually however the demand reached its limits and the supply outweighed it.

The Bottom Line

Like any other investment, investing into a buy-to-let property has to be taken in the context of one’s total portfolio. One should not over expose him/herself just to get into this market. On the other hand, if it is affordable, an investment into the property market is considered a good addition as it will not move in the exact same direction as other investments and can lead to more diversification.

Just like not all bonds are the same, not all shares are the same and so no, not all property is the same. Location, property size and other factors will have an effect on the rent-ability and potential saleability of any property one might consider. So advice from a professional is always recommended.

Furthermore, one should note that there are other ways of entering this market without actually buying property. There are many investments issued by property renting firms which one could invest indirectly into this market. One could also add different investments from different geographical locations and different sectors of the rental market. This could be done much cheaper and provide for much better diversification of one’s risk than actually buying property directly.




Do I need an Investment Advisor?


Many may wonder whether they should use an investment advisor or if they should simply invest on their own through more direct channels. This post will seek to give the pros and cons of both methods and show when one method might be better than the other. The aim is to go beyond the logical advantage of consulting with a person who has more knowledge in the subject. Are there any other advantages?

First of all it must be pointed out that there are many different types of investments and all have their different characteristics with respect to how they work, what risks they have and what potential returns they could produce. As a basic rule, the less complex the product the more one can invest on his own and use what is known as an Execution Only service. Basically this means that the investor simply uses an intermediary to execute his desired deal, without the intermediary giving any financial advice on the product in question.

From a legal perspective, financial advisors are only allowed to trade on an execution only basis when dealing in what are known as non-complex instruments. These are essentially investment products that are easy to understand, such as a direct bond, a UCITS Fund (as are many bond funds), a direct share or a bank account. When dealing with more complex products such as a derivative for which the price will depend upon the price of another instrument, then execution only cannot be used. So as an investor you can be rest assured that if you are unknowingly dealing in a complex instrument your financial advisor would point this out and would need to ask you certain questions to ascertain your capability of understanding the product, your financial situation and your risk appetite/invest objectives.

Would I save money by buying direct?

Not really. In Malta the usual practice is that clients are not charged for advice given and hence there is no direct cost involved if an investor would like to speak to an advisor before investing into a product. Furthermore, should a financial advisor give advice there are certain legal obligations relating to information gathering that such advisor would be bound to. Therefore, as an investor you can be more confident that you are making the right decision by investing into a product after speaking to an advisor since by doing so you would have more investor protection.

Are there any drawbacks to receiving advice?

As just pointed out, when an advisor gives financial advice, such advisor is more duty bound towards the investor. As a result the advisor would need to ask much more questions to attain more knowledge about the investor than when simply doing an execution only transaction. Therefore a drawback would be that it would take much more time and it would involve divulging much more information to the advisor when seeking advice. Questions would need to be asked about your income, your assets, your financial obligations and liabilities (example loans and their repayments). Further questions about your past investments and your knowledge in the particular product would also need to be made. Furthermore, the advisor would need to ascertain that your financial objections are in line with the product the advisor would be recommending to you.


Can I get information without getting advice?

Yes! Just because an investor has spoken to a financial advisor it does not mean that the investor has received financial advice. An advisor could have simply given information and not advice. Advice is something particular to an investor, it is based on the particular circumstances of the investor, it is a personal recommendation. If one simply asks an advisor for information on bond funds and the advisor explains 2 or 3 bond funds to the investor – that is not classified as advice. This means that the investor would not be required to give the advisor all his personal financial details, but it would also mean that the investor has less investor protection.

Therefore, as I described earlier, it all depends on the complexity of the product that the investor is seeking to invest in. If the investor simply wants to buy a Malta government bond which can easily be understood and is certain of his/her investment, then there is no need for financial advice. On the other hand, if the investor has a sum of money that he/she would like to be spread over many instruments and such investor also has different time horizons and objectives for his/her money – then at that point professional financial advice would be the best course of action. Even if the products recommended are non-complex products, the financial advisor would know how to use different products to meet different aims and cover different risks.

The Bottom Line

One has to keep in mind that his/her investments need to be considered as one whole portfolio and the overall performance of the entire portfolio should be considered. A professional investment advisor can take this holistic view only if he/she has as much knowledge as possible about the investor and hence it is important for investors seeking advice to give as much relevant information as possible to their advisor. Due to this last point it is very important to find a financial advisor that is experienced, knowledgeable, of good repute and that one trusts. Luckily there are many advisors in Malta that fit this profile. It is always important to ensure that whoever you decide to trust with your money is actually part of a licensed institution and is actually licensed himself/herself to give investment advice.

Happy Investing,