## Is it better for potential first home-owner to save first or jump first?

August 26th, 2008

Among the different class of property buyers, first home-owners are the most vulnerable. This is because they have the least outstanding equity, which means there is a greater chance of negative equity should they have to sell their home in a hurry. The equity portion of your property is its market price less the outstanding debt you owe on it. Let’s say the market price of a property is \$500,000 and you have an outstanding debt of \$450,000 remaining on the mortgage debt, your equity is \$50,000. Negative equity occurs when the market price of the property falls so much that it is below your outstanding debt. This means that if you liquidate the property, you will still owe the bank money.

Worse still, for first home-owner, at the initial stage of the debt repayment, most of the payments goes to servicing the interest, leaving very little for reducing the principal of the debt. For example, for a 30-year \$450,000 at 8.5% interest p.a., the first monthly repayment of \$3460.11 consists of \$3187.50 of interest payment. At the end of 3 years, the interest payment is \$3111.11. In other words, in the first 3 years, the first home-owner gets to reduce the outstanding debt by only \$11,000 while paying a total of around \$124,000!

So, given the amount of bad news regarding the economy lately, many potential first home-owners are becoming more cautious about jumping into the property ladder. Some may opt to delay their purchase in order to save more to ensure that they have a greater equity when the time comes to buy the property. But what if the property prices climb too fast while they save, resulting in them being priced out of the market by the time they are ready to buy? Or, should they jump in now or should they delay?

Well, the answer to this question will depend on these factors:

1. How much they save
2. Savings interest rate
3. Mortgage rate
4. How fast property price rise
5. How much deposit they already have

To answer this question, we constructed an Excel model to simulate the financial outcome between jumping in now or delaying to save. Our Excel model contains the following parameters:

1. Wage inflation rate- this determines the growth of monthly savings due to wage rise
2. Property price inflation rate- this is the rate at which property price rise per year
3. Savings rate- this is the interest paid on the savings
4. Mortgage rate
5. Initial deposit for the property
6. Extra repayment- the extra amount above the mortgage repayment that you can pay/save
7. Amount of to borrow
8. Loan period in number of years

So, we punch in the following numbers for our simulator:

1. Loan period- 30 years
2. Amount to borrow- \$450,000
3. Initial deposit- \$50,000 (i.e. 10% deposit for a \$500,000 home)
4. Mortgage rate- 7% (this is far below the current mortgage rate)
5. Savings rate- 5% (this is far below the current term deposit rate)
6. Property price inflation- 6% (this assumes that property prices will increase 6% p.a. forever and ever)
7. Wage inflation rate- 0% (this assumes that your wage rate get frozen for 30 years and thus, cannot increase your monthly savings amount or make extra monthly repayment for the next 30 years).
8. Extra repayment-0

These numbers are intentionally unrealistic to illustrate a point. Guess what is the outcome? By the 359th month, the property price will be \$2,709,193.95. If you choose to save, your savings will be \$2,711,133.30. This means, if you buy with cash on that month, you will have \$1935.35 left over. But if you choose the borrowing route, you will still have \$2,976.50 in outstanding debt.

Let’s tweak the figures a little. Let’s say your wage inflation rate is 3%. This means you can make extra loan repayments or increase your monthly savings as your wage grows. You will then find that your debt balance is always higher if you jump into the market now. Now, let’s make the property price inflation rate be 7%. You will find that it is more advantageous to save than to jump in for the first 6 years.

Playing around with the simulator, we find that if you are a high-powered saver, you can still be better off delaying your purchase for several years even if property prices appreciate (up to a certain point) in those years.