What are the best ways to save for a home deposit?

Finance & Fury Podcast

Welcome to Finance and Fury – For this week’s episode we are answering a question from listener David – surrounding some options to save for a home deposit

“The conventional wisdom is to save for, say, a home deposit in a bank account with as high as possible interest rate. However, recently it seems house prices are rising quicker than I can save, and interest rates are lower than CPI.

If my goal is to have a sufficient deposit in ~3 years’ time, what are your thoughts in keeping savings in a conservative (or even higher risk?) mutual fund instead? Wouldn't a low-risk fund be less risky than cash during an inflationary period?”

This is a great question – and brings up an important point – is the long term conventional wisdom on saving for a home deposit in cash no longer wisdom but a horrible idea? Especially in the current economic environment where your cash savings are earning a negative return in real terms when accounting for inflation – so let’s have a look at this and look at some alternatives

1. Historically - that conventional wisdom of saving for a home deposit in cash has been ingrained in the deposit saving strategy – and for a very good reason – that reason has been due to volatility in the short term – why take any risk on your savings if you can generate 4-5% p.a. in interest returns and inflation is only 2%?
   1. However – if you are getting 0% interest return and inflation is 3% - does this sound like a good idea?
   2. Also – home prices have been booming since interest rates have declined, with 2- or 3-year fixed rates being in the high 1% range – this has fuelled increases in prices which are beyond what cash can provide
   3. With home prices increasing and no returns on cash savings – you need to constantly save more and more to make up the short falls
   4. Example – want to buy a $550,000 home – need $110k as a deposit – plus $10,600 for stamp duty
      1. Say it will take you 4 years to save for this – but in this time property prices go up by 15% - same property is now worth $632,500
      2. Now you need $ in deposit and $14,300 in stamp duty – this is a further $16.5k in deposit and $3.7k in stamp duty – so this may take you a further 6 to 12 months to save for – in which time property prices can go up even further
   5. So what do you do? Just keep saving more, or look at investing these funds in the hope of getting a decent return?
      1. This is a very important question – due to this increase in price of property and the opportunity cost of keeping funds in cash – are there better alternatives?
   6. The issue with using savings to invest into growth assets, such as shares, especially with the aim that these funds increase in value in the short term, is that this is investing purely based around hope – and that hope is that the invested funds increase at a greater rate than a savings account can provide by the time you need to use the funds
      1. The irony is that these days a savings account will likely provide you a 0% return in nominal terms = a negative return when accounting for inflation and the price increase of property
      2. This leaves savers in a horrible position – either save more to minimise the short fall or – invest funds in assets that can provide an above property price growth level of return
         1. But this investment needs to help balance any risks – especially in the short term

What are some alternatives to saving in cash?

4. Let us look at a Conservative investment fund –
   1. Conservative funds are those that have the majority of their allocation in defensive investments
      1. Their allocation is normally a majority of FI assets and some cash – with a smaller allocation to shares – both Aus and Int to help generate some growth returns
      2. The aim of these funds is to normally get a return of a few percentages above cash rates
   2. As an example – there is the Vanguard conservative index fund – either in ETF or managed fund versions
      1. The comparative returns of this fund have been good – especially when compared to cash –
      2. Cash returns over the past 3 years on average has provided 1% p.a. which is far below most peoples target when incomes to achieving a savings rate

• How has the conservative fund performed? Over the past 3 years it has provided a return of 6.5% = 4.5% of this has been income with around 2% being capital growth

5. Looking even further out – you have the 5-year average returns of 5.54% – the income return has been 4.75% and growth has been around 0.68%

5. In hindsight – and as a comparative tool – investing funds in the vanguard Conservative ETF would have provided additional capacity to save than pure saving funds in cash – but investing Is always perfect in hindsight
   1. Conservative fund has around 62% in FI and 8% in cash – total of 70% defensive – then has 18% International shares and 12% Australian shares – this significantly reduces its volatility when markets take a downturn
   2. Look at volatility – Looking back over time –
      2. Drawdown analysis - What happened in GFC? – In 2008 – fund lost 2.5% - but then had a total drawdown of 10% by 2009
         1. Recently had a drawdown in 2020 of 7.5% - but thanks to markets recovering it didn’t stay there for too long
         2. The average larger drawdown beyond the two outliers has been about 2.5% when the market does down (has occurred 5 over the past 18 years)
      3. Rolling return periods – 1 year rolling returns – there was a 2 year period where the returns were around -5% - if you invested in 2008 then by 2010 you would have not made any returns
   3. Conservative funds – high allocation to bonds and cash – allocation to shares as well –
   4. Compare the opportunity costs for savings between getting 0% and 5% - based around historical returns a conservative fund would have worked better
6. But what about looking forward – everything in hindsight is a fantastic strategy – but how would this form of conservative investment fair if interest rates were to rise –
   1. Likely not well – given the make up of the funds is 62% fixed interest – this asset class would likely suffer in pricing if interest rates rise –
      1. It invests in index funds – the index of bonds is many large countries Government bonds - due to the size of debts that governments have issued on fixed interest
      2. These bonds have QE propping up demand for the bonds – but if interest rates need to go up due to inflation concerns, and the liquidity dries up in response, what happens to the bond market?

• Pricing of a bond – every bond is issued with a fixed coupon – often that of the interbank cash rate of the nation
  1. Say interest rates of Aus go back to 1% - would you buy a bond for $100 if it was only paying 0.1%? Likely not, as you may want to save funds in the bank and get 1%, or close to it – so what has to happen to bonds in response to incentivise investors? The price of the bond needs to drop – if it is 10 years out from maturity, the price of the bond would be $91 – if were a 30 year bond, the price would be $77 – remember each of these bonds would have a current price very close to their face value = a potential loss of 10-20%

1. Therefore, cash may actually provide a better return in the short term than a conservative fund – which in this time period may likely have a near 0% if not negative return.
2. As over the last few quarters – the aggregate bond index can decline by about 0.8% if fears of inflation and interest rate increases are priced in

1. The flip side of this – if interest rates were to increase, property prices may stagnate or even start to decline – this would mean you need less in savings to afford the same home – but it would also mean that you likely have less in a conservative fund

Alternative options – if you are a first-time home buyer ­– you may have some better alternatives than saving in personal funds

1. First home SSS – Using superannuation is a viable strategy in most situations, even though it can be a little restrictive.
   1. It essentially allows for larger savings through the reduction in total tax paid on the level of savings (through not receiving it as a taxable income).

How it works:

2. From 1 July 2017, individuals can make voluntary contributions of up to $15,000 per year and $30,000 in total, to their superannuation account to purchase a first home.
   1. Pre tax conts. – Taxed at 15%, along with deemed earnings, can be withdrawn for a deposit.
   2. Done through employer – Salary sacrifice – rather than saving personally
   3. Self employed – Can still do and claim a deduction on personal conts later
   4. Must remain within concessional (pretax) cap of $27,500 – this means that whatever your employer puts in, plus your SS needs to be below $27,500
3. Withdrawals will be taxed at marginal tax rates less a 30 per cent offset and allowed from 1 July 2018.
   1. Amount of withdrawal = Net contribution plus deemed return (90 day bank bill plus 3%)
      3. 3.1% currently – will change as the RBA cash rate changes
   2. Who is eligible - You can start making super contributions from any age. However, you must be 18 years old or older to request a determination or a release of amounts under the FHSS scheme.
      1. Also, you must have: never owned property in Australia – this includes an investment property, vacant land, commercial property - Eligibility is assessed on an individual basis. This means that couples can each access their own eligible FHSS contributions to purchase the same property. If any of you have previously owned a home, it will not stop anyone else who is eligible from applying.

Examples and looking at a comparison -

1. Individual earning - $60,000 a year (or anyone earning between $45k-$120k for a rate of 34.5% including the Medicare levy) – Never bought a home before
2. They direct $10,000 of pre-tax income into superannuation
   1. increasing her balance by $8,500 (after 15% tax)
3. Continue for 3 years – Contribute up to $30k in total
4. Withdraw $26,700
   1. Net contributions of $25,500
   2. Plus deemed earnings on those contributions (3.1%) each year the funds were sitting there
5. Withdrawal tax of MTR (34.5% inc Medicare levy) minus 30% offset
   1. $1,202 in tax paid
6. Net withdrawal - $25,500
   1. $5,850 more than if saved personally in cash ($11,700 more if you are a couple than if you were saving these funds personally)
   2. Now – if you had invested your net income at the same rate in the Vanguard fund – left with $20,955 – so even at a higher earnings rate of 6.5% - the FHSSS would have provided a better result
7. This scheme has two things working for it –
   1. First is that the returns are guaranteed – regardless of what your super does, the deemed earnings will be the RBA cash rate plus 3%
      3. The downside to this is that if your superannuation does decline, then you are withdrawing a larger lump sum whist the account value may be down – as an example, your net contributed amount may lose 10%, but you would still be withdrawing an amount as if it had earnt the 3.1% p.a.)
   2. Secondly – it is tax effective – the saving of funds through superannuation allows you to save some additional funds through reduce your tax burden
   3. The downside is that a maximum of $30,000 can be put towards this, which after tax is $25,500 – or $51k for a combined couple –
      1. Given that property is rather expensive – this may get you half of the way towards a deposit for the average home in some major cities, excluding Sydney or Melbourne

This leaves the option of continuing to save either in cash or looking at an alternative option – such as investing in a conservative ETF –

1. Monthly investing into a conservative fund –
2. The longer the timeframe, the better –
3. If you are 10+ years away from a deposit, then you can look at something higher growth
4. In the end – it is impossible to say what will provide you with the best return in the short term – i.e. 3 years – as nobody knows the future
   1. But over longer periods of time, statistics and averages start to play a bigger role

I hope this helps to clarify things.

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