If you start planning now
There are many reasons that compel dentists to begin investing including funding their children’s private education. Private school fees can cost in the range of $10,000 to $30,000 per year (at the moment anyway – they increase each year). There are other costs in addition to fees including computers, uniforms, extra-curricular activities and so on. The rule-of-thumb is to add another 10% onto the base fees. Education expenses can put quite a dint in your cash flow if you don’t plan for them in advance.
The cost of education
American lawyer, Derek Bok said “If you think education is expensive, try ignorance”. With that in mind, it was with equal amounts of interest and distress that I read an article a few years ago about the average increase in private school fees. It noted that between 2001 and 2012, the average fees from 6 elite Victorian private schools nearly doubled over that period (increased by 96%). That equates to an average increase of 8% p.a. The Australian Scholarship Group (ASG: a not-for-profit friendly society with the sole purpose of investing to fund education for its members) projects that if you had a child today, the year 12 school education would cost you $67,149 (i.e. in 17 years’ time). ASG have an online calculator that you can use to predict the cost for your situation.
I have used ASG’s projected estimates in my analysis below. I have compared four strategies that aim to fund private school fees that people could consider implementing.
1. Develop a regular savings plan
One simple option is to open a high yielding bank account and start marking regular contributions when your child is born. To fund one child through private school education, I have worked out that you would need to save $1,000 per month (increase by 3% each year to keep abreast of inflation) from when the time they are born until they finished secondary school (i.e. over an 18 year period). I have assumed an average interest rate of 5% p.a. over that period and allowed for tax on interest earnings. As noted above, I have used ASG’s cost projections.
In total, this requires you to save just over $280,000 (principal) over the 18 year period.
The chart below projects the savings account balance (per child) over the 18 year period
2. Buy a property and sell when schooling begins
Assuming your child is born in January 2014, you will need approximately $310,000 of cash in the year 2026 to fund then next 6 years of secondary school education. I projected that if you purchase a $400,000 investment property and sell it in year 2026 (after 12 years of ownership – just before the child starts secondary school), you will net cash proceeds of approximately $340,000 after paying for taxes and selling costs. This will be enough to fund the next 6 years of private secondary school fees. I have made the following assumptions in my projections:
- the property will increase in value by an average of 7% p.a. of the 12 year ownership period which is conservative for an investment grade property (typically an investment grade property should increase between 8% and 10% p.a. over the long term)
- The average mortgage interest rate was 7%
- You will pay for a buyer’s agent (property advisor) to select an investment grade property (fee has been included); and
- I have allowed for 2.5% for selling costs.
In terms of the cash flow cost of the property, I have projected that the property will cost the investor just under $1,000 per month (after tax) in year one. However, as the property’s value rises (and so does the rental income), that cost should reduce. For example, by year 10 the property will cost approximately $420 per month. In total, this strategy will cost approximately $89,000 after tax to hold the property for 12 years – significantly less than strategy 1 above.
The chart below sets out the annual after tax cost to hold the investment property for 12 years
3. Buy a property and borrow to fund education
Following on from the second strategy above (i.e. buy and sell an investment property), an alternative to this strategy is to not sell the investment property before the child starts school but instead retain it and borrow against the equity in the property to fund school fees. After the child finishes secondary school, the decision can be made at that time to either sell the property and repay the school loan or hold onto the property for a little longer. By the time the child finishes secondary school (year 2032), I have projected that the property will be worth $1.35 million and there will be two loans secured by it. The first loan is the tax-deductible investment loan of $431k (use to purchase the property) and the school fee loan of $348k (so the loan to value ratio is just under 58%). If the investor sold the property after the child finished secondary school, I estimate that they would net approximately $330,000 in cash after repaying both loans, selling costs and taxes.
In terms of the cash flow cost of this strategy, you will need to pay interest in respect to the loan used to fund private school fees. As you draw down the loan each year, the interest cost increases (as depicted in the chart below). The cash flow cost of this strategy over the 18 year period totals $167,000 which is more than strategy # 2 above (i.e. $89,000). However, taking into account the cash sale proceeds (when the property is sold) of $330,000, the strategy is actually profitable by approximately $163,000 ($330k less $167k). Essentially, you need to spend an extra $78,000 in cash flow between years 13 and 18 (i.e. this strategy costs $167,000 versus strategy # 2 at $89,000) to make an additional $330,000 in cash. Assuming it’s affordable, that makes sense to me.
The chart below sets out the annual after tax cost to hold the investment property and borrow to fund school fees (the interest cost) over an 18 year period
Let me explain why this strategy works better than strategy # 2. I have projected that the property will increase in value between year 17 and 18 (i.e. the last year before the sale of the property) by approximately $88,500. I have projected that the cost of education the last year of second school (i.e. year 12) will be approximately $67,000. Your loan will increase by this amount. Therefore, your net worth has increased by $21,000.
4. Regular geared investments in to the stock market
The fourth alternative strategy that I compared was a regular share market investment plan with gearing. The advantage of investing in the stock market (compared to property) is that you can invest regularly in smaller amounts. In addition, you can establish regular gearing. In this strategy, I assumed that you would invest an amount of $560 per month ($6,720 p.a.) of your own money into a managed fund beginning when your child is born. In addition, each month you would borrow the same amount ($560) to also contribute into the investment (so the total contribution is $1,120 per month funded by 50% borrowings and 50% capital). You would need to increase the contribution by approximately 3% each year to keep up with inflation. When your child starts secondary school you would need to sell down your investments gradually to fund the fees. Once the child completes their schooling, you would sell any remaining investments and repay the loan.
In terms of cash flow, this strategy costs you $560 per month (plus inflation) for 18 years – which totals approximately $160,000. However, the managed funds will generate some income returns (i.e. dividends) net of taxes and interest. The investment returns (after tax, capital gains tax and interest) over the 18 year period will be approximately $13,000 after tax so the net after tax cost of this strategy is close to $147,000.
In preparing these projections I have made the following assumptions:
- A growth rate of 7% p.a. (as I wanted to use the same assumption as I did for strategies 2 and 3 above)
- Income rate of 3% (i.e. dividend yield); and
- Interest rate of 7% p.a.
In terms of a suitable managed fund, I would typically recommend a low-cost passive-style investment such as an index fund (Vanguard and State Street are two main providers in Australia) – index to ASX50 or ASX100. These funds typically only charge a management fee of 0.30% to 0.40% – well less than the average active fund.
How do Education Savings products stack up?
You may be aware that there are some providers that sell products aimed at helping you save for education. I believe these products are popular in the USA but less so here. According to an article by Choice magazine, there are only two education savings plan providers being Australian Scholarship Group and Lifeplan (which use a product from CBA). These plans are operated as a ‘scholarship plan’. This entitles the provider to recover the tax paid on investment earnings whenever those earnings are used to pay eligible education expenses. The student may have to pay tax on those earnings when they are paid out. This works well for adult students (i.e. over the age of 18 – to fund university studies for example) but doesn’t work as well for minors (i.e. secondary school students) because their tax free threshold is only $416 p.a.
I have reviewed the above products and on the whole, I don’t feel that they provide a superior alternative to the four strategies above. They appear a bit convoluted, lack flexibility and are more expensive (i.e. the investment management fee is 1.5% compared to an index fund at 0.30% to 0.40%). On the whole, they aren’t good options – probably why they are not that popular.
And the winner is…
Obviously the clear winner on paper is buying an investment property, borrowing the school fee costs and selling the property when your child finishes school (or later depending on affordability). However, the best solution for you depends on your comfort level with debt, your investment preferences and your cash flow position (amongst other things). There is however one addition important point that I need to make. The quality of the asset you invest in will greatly determine your success. Invest in the best quality assets and your strategy will likely work out for you. It doesn’t matter how perfect your strategy is – no strategy can make up for poor quality assets.
Most dentists have strong cash flows. Therefore, the challenge for you is to develop smart plans and make your money work hard for you… not the other way around.
This article was written by Stuart Wemyss and was published in the April 2014 edition of the ADA News Bulletin. Click here for a printable scan of the article.