Case study 1: Funding a child’s education
Dean and Jenny are in their 30s and have a four-month-old baby, Alice. To ensure they’ll be able to afford Alice’s education, Dean and Jenny decide to start a dedicated savings plan. They estimate that by the time Alice is 11 they will need to have saved $84,000 (in today’s dollars) to meet her annual private high school fees of around $14,000 for six years.
Dean and Jenny choose a managed fund with a regular savings plan option. They kick off their savings with a lump sum of $5,000 and decide to invest a further $450 every month. Based on projected earnings of 7.5% pa and taking inflation of 2.5% pa into consideration, this means they should accumulate around $86,000 in 11 years. Provided Dean and Jenny keep the savings plan going for the entire 11 years, they should be able to fully fund Alice’s private high school education when the time comes.
By maintaining the discipline of making monthly investments without touching these savings, Dean and Jenny will reap a great reward from compounding interest. This occurs when you leave the interest you earn in the account, so that you begin earning interest on your interest. The effect may be small at first, but if you leave the interest to accumulate in the account it can gradually snowball over time and significantly boost your savings.
1. The estimated balance required and estimated school fees are in today’s dollars.
2. The projected earnings are before fees have been taken into account. No allowance has been made for taxation, including capital gains tax on investment earnings. Please remember fees and taxes have an impact on long-term returns.
Case Study 2: Borrowing to invest (gearing)
Sarah wants to save for a deposit on her first home. She already has savings of $40,000 and decides to take out a margin loan of a further $40,000. With double the money to invest, she has the potential to earn a greater return than if she just invested her own money. However, Sarah understands that borrowing to invest (a strategy known as gearing) also means she has the potential to lose a lot more – and if her chosen investments don’t perform well, she will have to repay the loan regardless.
Sarah chooses to invest her money in a managed fund. As you can see in the table below, based on an annual return of 9%, at the end of seven years her investment would be worth around $74,000. If she’d not borrowed any funds, she’d have around $64,000 using the same investments.
* Figures shown after tax and loan interest costs have been paid. Assumes the same growth investment for each strategy with an average return of 9% pa (4% income plus 5% growth, with a 50% franked component of income return). Return assumes dividends are reinvested, a marginal tax rate of 41.5% (including Medicare), and an average margin loan interest rate of 7% pa. Excludes brokerage and any other fees. Inflation has not been considered. Over long periods, inflation can reduce the purchasing power of your money.
** This example is for illustrative purposes only. It does not represent the past or expected performance of any particular fund, portfolio or investment. Any changes to taxation, loan interest rates, investment returns, or the other assumptions will affect the outcome.
Sarah’s strategy is easy and tax-effective. Even after allowing for the interest payments and the final repayment of the loan, she is $10,000 ahead. Because she is borrowing for investment purposes, she may also be able to claim the interest paid on her loan as a tax deduction, further increasing the value of her strategy.
However, it is important to remember that borrowing to invest does involve significant risks. Although it has the potential to magnify gains, it will also magnify any losses suffered if the value of your investment falls. Acquired Wealth Pty Ltd can help you decide whether a geared investment strategy is appropriate for you.
These case studies are for illustrative purposes only. They are not based on a particular person’s circumstances and are not personal advice. As this information has been prepared without considering your objectives, financial situation or needs, you should consider its appropriateness to your circumstances. You should seek assistance from your financial adviser before acting on this information. AIW Dealer Services ABN 59 153 322 420, AFSL 414256.