Should you start saving - Now?

Saving for a deposit is one of the most important things you can do in your life. In our work at Peach we are constantly coming across people who are enjoying the whole of their income, renting and saving very little.

Its amazing how much harder they're making life for themselves - how short-lived are the benefits of not saving . To help people appreciate just how much difference it can make to their lives, I've done some calculations comparing the fortunes of a household that takes the plunge, steels itself to save a deposit and then pays out a little more each month for repayments on a home loan.

People with some savings record can generally borrow up to 95% of the value of a house - sometimes 100% - to help them finance its purchase. There are of course extra costs - stamp duty on the property, on the mortgage, conveyancing and so on. But first home owners also get a generous grant from the government - of $7,000.

Including any access you can get to the $7,000 First Home Owner's Grant, a good rule of thumb is that you need around 10% of the value of the house to purchase it. Between 1% and 4% disappears in stamp duty and around another 2% goes in 'lenders mortgage insurance' on home loans with a loan to valuation ratio (LVR) of 95% and around 3% on home loans with an LVR of 100%. (Lenders mortgage insurance is taken out by lenders to cover them if you can't meet payments and the value of the house cannot meet your debt. Remember it doesn't insure you, it insures the lender).That means that after spending 5% on the value of the house the rest of your 10% deposit secures a home loan of 95% of the value of the property, or a 3-5% deposit secures the house with a 100% home loan.

Also buying off the plan is a huge help if the size of your deposit is the problem. Not only does the First Home Owner's Grant rise from $7,000 to $10,000 in most instances [this advice is now out of date since the Government reduced the payment. NG], but you are only paying stamp duty for the transfer of land. You don't pay additional stamp duty for the value of the building - you're already paying 10% GST for your trouble but that's built into the price of the new house! So you get much lower stamp duty payments. Even so you still have to pay hefty mortgage insurance fees.

And sorry to tell you this, but there's another catch! Lenders are very wary of first homebuyers not being prepared to make the sacrifices of paying more in their mortgage than they have in rent before. So they usually want evidence not just that you've got the deposit, but that you've saved the deposit. If you've got a gift from Granny you should definitely talk to us to see what we can do, but unless you can keep your borrowing below 90% of the value of the property, its much harder than if you can show you've saved without Granny.

But the rewards are there for those who want to save. Its extra-ordinary how important that first decision to save and buy is. It might seem unpleasant for a while, but its not long before the law of compound interest kicks in and people find that their wealth is rising far beyond what it would have done if they stayed renting.

Just to give you an idea how important that early saving for a deposit is, just have a look at the figures below. We've taken a very conservative example where rental yields (the rent divided by the price of the house) are 5% and the home loan interest rate is 6% (we can currently get good flexible loans at 5.35%). That is below the current bank interest rate. (In fact for many cheaper houses, rental yields are well above the housing interest rate). And capital growth of houses is a low 2%.

With these assumptions we two hypothetical households; one where people don't save and rent instead, the other where they save to buy. In the former scenario their rent on a $100,000 house starts at $5,000 per year and rises by 2% each year - with the capital value of the house they're renting. In the latter scenario, after paying out nearly $9,000 in their first year (to cover buying costs, and a year's repayments less the first home owners grant) they settle down to paying $6,900 per year or $575 per month. That's $1,800 per year more than the renters in the second year. But over time the position powerfully reverses itself. The buyer's repayment stays the same while the renters rent rises as their landlord gradually increases the rent - to take account of the rising value of the house the tenants could have bought! So as the renters rent rises not only does the buyers repayments stay the same - the buyers equity rises each year not just because the loan gets paid off, but because the house price rises.

These calculations are 'real' rather than 'nominal'. That is the 'real' price of the house and the rental payments rise by 2% more than inflation. Low steady Inflation actually helps the house buyer more, because it gradually diminishes the real value of the repayments.

After five years, the gap between payments has fallen to $1,500 per year, but the home owners have got $20,000 equity in their new home! As the home loan progresses, it gets smaller, so each month less of the repayment goes to paying interest and more goes to paying off the principle. At year 8 the difference in payments has fallen to under $100 per month. The owners have paid a little over $14,000 more in repayments, but have effectively 'saved' nearly $32,000 - as that's the amount of equity they have in their house. See Scenario 1 below. At this stage they can go out and borrow another $20,000 for an investment property and the 'virtuous circle' goes round again.

Now lets change some of the parameters only a bit - and in some ways make them more realistic. Often one reason people have trouble saving is that pay a lot of rent. In some (usually less affluent) areas, rental yields are up to 10% - that is renters paying up to 10% of the value of the house in rent each year! We've assumed a rental yield of 7%, interest rates of 6% and real capital growth in the value of property of 3% instead of 2% as earlier. In this scenario, because rental yields are higher than interest rates our owners pay less than renters immediately they have met the up-front costs of buying and establishing the mortgage. Here's a table of how much less they pay each year compared with the renters.

Savings each year compared with renting

2	3	4	5	6	7	8
$308.35	$524.65	$747.44	$976.92	$1,213.27	$1,456.72	$1,707.47

So the buyers pay less and save more! Net wealth is $24,000 after five years and nearly $40,000 after eight years - with the capacity to borrow another $27,000 for investment. See Scenario 2 below.

I hope that's got the chronic renters motivated. A subsequent newsletter will offer a whole range of tips on how to save for a deposit.

Cheers


AKA Nicholas Gruen

Scenario One

Scenario Two

Please note: These calculations are based on the best information provided to Peach in January and February 2002. They are provided as strictly indicative calculations. It is possible that rates for any of the costs charged differ from those provided in this calculation. This could be a result of human error, use of specific mortgage insurers other than those which may be encountered in a transaction , or changes in stamp duty and or other charges by governments of which Peach is unaware. Further some states may impose charges other than the ones outlined here. Generally these figures will be checked by your lender prior to approval and by your conveyancer prior to settlement. No responsibility is taken by Peach Home Loans for the accuracy of the figures provided. Readers of this newsletter should not rely on any of its contents before checking first with Peach Home Loans or some other professional. We deny to the extent possible by law all legal liability to any person who does not discuss with us their plans. Borrowers should never assume that they qualify for a home loan will before receiving an unconditional home loan offer from a reputable lender.

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