It was reported over the weekend that private school fees have increased by 3.6% over the past year. However, the longer-term trend is closer to 5% p.a. Private school fees are tipped to soon exceed $40,000! That is a big hit to after-tax cash flow. This blog compares three financial strategies you can use to fund future school fees.
What is the future cost?
There are two things to keep in mind with respect to future education costs. Firstly, the average rate of fee increases is close to 5% p.a. Secondly, these expenses must be paid from after-tax income – so you have to earn a lot more pre-tax in order to meet these costs.
A child born this year will most likely start secondary school in year 2031. Assuming fees increase 5% p.a. and inflation remains at 2% p.a., the total cost of secondary private school education will be $280,000 in today’s dollars. A parent will need to earn at least $460,000 before tax (in today’s dollars) over a 6-year period to meet these costs – an average of $75,000 p.a. per child.
I am sure you agree that this is a substantial cost and one that you must plan for as early as possible.
Steer clear of education funds
The most prominent education fund producer is ASG. It creates structured savings plan so that parents will be better positioned to meet future education costs. However, their fees are high and investment returns are terrible. Parents would be far better off following one of the lower-cost, more transparent options below.
Strategy One: Park savings in your home loan
The best place to save money is to park it in your home loan and redraw it whenever you need it. The reason being is that the home loan interest rate is much higher than the deposit rate. At best, you might receive 2.5% p.a. in interest for money in a savings bank account. The home loan mortgage interest rate is currently around 4% p.a.
I completed my financial projections using a home loan interest rate of 5% over the next 18 years (the average rate over this time will likely be higher – but I’m being conservative). I worked out that parents would need to direct additional cash of $1,200 per month into their home loan over the next 18 years in order to fund their children’s school fees. That is, in year 2031 they would redraw these extra repayments from their home loan to pay for their children’s school fees as they are incurred.
This approach (i.e. $1,200 per month for 18 years) costs $258,000 in after tax dollars – slightly less than the $280,000 above – because of the interest saving generated by the extra repayments.
This approach is very low risk because your return (being the home loan interest you will save) is certain. That is, home loan interest rates will almost always be between 3.5% and 8% p.a.
You can also park money in an offset linked to an investment loan – although it is less effective than a (non-tax-deductible) home loan.
Strategy Two: Invest in the share market
This option includes investing a regular amount in the share market. You don’t need to ‘pick’ shares in order to implement this strategy. Instead, you can use a low-cost, diversified index fund from Vanguard to do this. This means you only need to buy shares in one stock (codes are VDHG or VDGR for example) each month in order to make these investments. This one stock has exposure to Australian and international shares, emerging markets and some bonds too. It is very simple. You can use a low-cost online trading platform such as Commsec or CMC Markets to do this.
Long term equity market returns (dividend income plus growth) have been circa 10% p.a. over the past 30 years. However, to be conservative, I will assume returns will be 8% p.a. over the next 18 years (being 4% income plus 4% growth).
I calculated that parents would need to contribute $14,500 per year ($1,210 per month) into a share portfolio over the next 18 years. They would gradually liquidate the share portfolio to fund the school fees as they are incurred.
Strategy Three: Invest in a property and sell it when they finish school
This strategy would involve borrowing to purchase an investment property, then accessing the equity (via borrowings) in that property before you child starts secondary school to fund school fees. You could then sell the property when your child finishes school to repay all loans.
I assumed an investment purchase acquisition of $750,000, a conservative capital growth rate of 6% p.a., a gross rental yield of 3%, allowed for expenses and assumed an average mortgage interest rate of 6%.
The cash flow cost of this strategy over the 18 years of ownership amounts to approximately $210,000 which is a lot lower than the other two options.
The net equity in the property in 18 years’ time (after allowing for repaying the original loan and CGT) is circa $900,000. Don’t forget that you will have an additional loan which you used to pay for the school fees and that would be circa $450,000. Therefore, this strategy leaves you with a surplus (cash proceeds) of $450,000 after tax.
The breakeven capital growth rate (needed to generate enough wealth to cover all schooling costs) is only 4% p.a. A well-selected, investment-grade property should definitely generate substantially more growth than this over the next 2 decades.
Why does property win?
Here’s a summary of the results:
|Park in home loan||Invest in shares||Invest in property|
|Value at end||Nil||Nil||$450,000|
The property strategy produces the best outcome for three reasons:
- The returns I have assumed are higher for property. In the home loan strategy, I assumed an interest rate of 5% p.a. In the share market strategy, I assumed a gross return of 8%. And in the property strategy I assumed a gross return of 9% (growth plus income). I assumed a high gross return for property simply because it has half the volatility rate than shares.
- Property provides less of its total return in income and more in capital growth. See this blog for why that is important.
- Only the property strategy includes borrowing to invest. Borrowing to invest is a higher risk strategy and does not suit all people. Also, borrowing to invest magnifies investment returns – both positive and negative.
Which strategy is best for you?
Of course, that depends on many things such as the age of your children, your expected income, your asset base, your risk profile and so forth. The point of this blog is to point out that there are a few strategies that can be considered and that it’s very important that you implement said strategy as-soon-as-possible. The longer you leave it, the more painful it will be to fund private school education.
If you want to send your child to a private primary and secondary school, then it’s even more important to have a plan – as I have only considered secondary school costs in this blog.
The best time to start planning for education costs was yesterday. If you didn’t do that, the second-best time is to start today. We can help.