Many grandparents take great pride in contributing to their grandchildren’s school fees. Indeed, some estimates suggest that at least 60% of private school students have their fees at least partly paid by their grandparents.
Whenever money is saved for a specific purpose, such as paying school fees, care needs to be taken not to make the mistake of ‘mental accounting.’ Also known as the ‘two-pocket theory,’ mental accounting describes people’s tendency to separate and categorise money according to some artificial criteria, such as its source or intended use.
Mental accounting means that people forget that money is fungible – possibly the best word in finance – which means that the same dollar can be used for a variety of purposes. Just because in the future I intend to pay school fees, does not mean I need to keep the relevant amount of money separate right now. It might make more sense to mix that money in with my other finances and only take it out when I actually need it.
In most cases, parents of young children are also paying off a personal home loan. Personal home loans are a form of non-deductible debt. Non-deductible debt makes wealth creation difficult. A person paying tax at 32.5%, with a home loan of $375,000 charging 5% interest, must earn $27,777 just to pay the interest. Looked at another way, paying off non-deductible debt achieves the equivalent of a 7.4% pre-tax return.
Because of its expense, reducing non-deductible debt should be step 1, 2 and 3 of any serious wealth creation strategy. Despite that, many clients do not think to prioritise the repayment of non-deductible debt. And many grandparents do not realise that helping their adult children reduce their non-deductible debt will have a flow on effect when it comes time to pay expensive school fees.
Consider a young couple with a mortgage and two pre-school children. Not unusually, their parents have offered to help with private secondary school fees in several years’ time. To be sure that they can honour their promise, grandma and grandpa have put that money aside. It is sitting in a term deposit earning 2.5%. This is an example of mental accounting– money has been set aside for school fees when it could also be used for something better in the meantime.
A simple strategy is to lend the money interest-free to the daughter or son and park it against their expensive mortgage. Depending on marginal tax rates, the same money would now earn the family up 7.4% pre-tax. Combined with this loan from their own parents, mum and dad maintain the current level of debt repayments.
Over several years, the effect of this is to dramatically reduce their non-deductible debt. Remember, any reduction in debt means an increase in wealth.
This is great news, because the simplest way to make anything more affordable is to become wealthier. Remember, money is fungible. When the time comes to pay the school fees mum and dad will be a lot further ahead in terms of their loan repayment. This will let them take a repayment break while they pay their share of the expensive fees. Alternatively, mum and dad might even redraw some of (their own) extra repayments so that they can pay the school fees without compromising other spending. In a perfect world, mum and dad have completely repaid their home loan and simply redirect the money that they were spending on repayments towards their share of the school fees.
Exactly how this strategy provides its benefit will vary from case to case. What will not vary is that using savings to reduce non-deductible debt – even temporarily while you save for a specific expense such as school fees – will always have a positive impact on wealth.
So, if you’d like to know more about how grandparents can provide financial support to their children and their grandchildren, talk to us today.
The tax advice component of this article was produced by Dover Financial Advisers, a registered tax (financial) adviser.