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The paradox of thrift

15:26 03/04/2013
We all know the proverb: ‘Never a borrower or a lender be.’ As with many proverbs, this concept works best when you are firm on the principle whilst retaining flexibility on the methods you use towards your objective. At times, borrowing money can in fact be advantageous.

In a previous article, I highlighted the importance of spending less than you earn. Peripheral eurozone countries are currently having this message rammed down their throats. Many economists, however, have pointed out an inherent flaw with global austerity: if everyone saves more, who makes up for the shortfall in purchases? If less is bought, economies shrink, making it more difficult to pay back debts, leading to the need for more austerity. So, while thrift can work on an individual level, it can be problematic on a national level.  Moreover, at times it is also sensible for individuals to expand their balance sheet (become a borrower). In particular, a mortgage loan can be advantageous in many ways.

The strategy: manage your finances as if you were running a business

The objective should be to make the most efficient use of your income and capital. This, in turn, requires a sensible loan strategy.  Prudent borrowing is not only beneficial for individuals and companies it is also good for the economy however, getting any sort of loan, let alone the most optimal, is becoming more difficult. 

Historically, high street bank profits were derived primarily from three areas: savings accounts, loans and the sale of financial products, such as investments and insurances. All three areas are problematic right now. 

It was once said that banks specialise in lending money to people who can prove they don’t need it. In Belgium, lending practices are not always based on commercial logic, so even this type of potential borrower can struggle to obtain flexible mortgage finance. The current parlous state of banks in Belgium and elsewhere has led to even greater inflexibility. So be warned: the loan package your bank will be keen to promote may be somewhat different from the type of loan that suits you best and may include some expensive add-ons you neither need nor want.

Savings: Banks are under pressure to deleverage – in other words, to reduce the percentage of loans they offer relative to the money they hold from savers. However, as interest rates are close to zero and below the rate of inflation, banks are finding it harder to attract and keep savers’ funds.

Financial products: Guaranteed rates are low and stock markets results since 1999 have been poor. With the prevailing unemployment concerns, customers are increasingly reluctant to tie up their capital.

Lending: The property market in Belgium has remained robust, so mortgage finance is the one area of business where banks are still able to attract customer interest. However, they are becoming extremely reluctant to lend unless they can persuade the potential borrower to buy other products.

Borrowing as little as possible when buying your home may seem prudent however, it is usually wise to borrow more than the minimum required so as to retain some of your own funds. Ideally, you would want a permanent loan where you pay only interest to the bank, with the capital being repaid on the sale of the property. This enables you to direct the usual monthly loan repayments into your own investment vehicle, which you can dip into whenever you need to buy large-ticket items that cannot be covered by your monthly salary. This system avoids cash flow difficulties and expensive short-term loan facilities and ensures you are not beholden to banks to grant you credit, as you always have access to your own reserves. In addition, the effects of inflation will mean that when you eventually do repay the loan, the value is likely to have fallen significantly in real terms.

 Philip Curran is an independent financial adviser based in Brussels and can be contacted at [email protected]

This is an updated version of an article which first appeared in The Bulletin in April 2012.

Written by Philip Curran