First Home Loan Deposit Scheme: The 3 things buyers need to know before applying for a 5% deposit

The Coalition’s First Home Loan Deposit Scheme could save first-home buyers years in accumulating a 20% deposit. But it could also cost the buyer about $53,000.

Crunching the numbers on a hypothetical first-home buyer scenario shows that while the scheme is a better alternative to securing lenders mortgage insurance, it will cost tens of thousands more than a 20% deposit over the life of the loan.

The First Home Loan Deposit Scheme (FHLDS), while ultimately adopted by Labor, differed from Labor’s broader campaign of housing affordability. Rather than lowering house prices through tax reforms, it creates a quicker, but more expensive way, for first-home buyers to enter the existing property market.

First-home buyers should look long and hard at the scheme before jumping at it, paying particular attention to additional servicing costs as well as factoring in potential capital gains and the cost of renting while saving.

What is the First Home Loan Deposit Scheme all about?

From January 2020, the government will lend approved first-home buyers the gap between 5% and 20% deposit.

A 5% deposit is also known as a “95% loan-to-value ratio [LVR]” because the borrower takes out 95% of the property value. Anything below a 20% deposit (or an 80% LVR) is considered risky – especially in a declining market.

Therefore, high LVR loans can incur lenders mortgage insurance (LMI). LMI is charged to borrowers to protect banks in the event of the borrower not being able to repay their mortgage.

While many just add LMI to their mortgage, it is a substantial cost. An entry level property with a 5% deposit without a guarantor could incur LMI costs of about $17,000.

The proposed scheme would support 10,000 first-home buyers each year. To put that in perspective, there were about 109,000 first-home buyer loans secured in the year to March - so less than 10%.

First-home buyers would qualify for government assistance if they are approved for a loan, have saved at least 5%of the value of a property, and earn below a certain income. Singles qualify if they earn up to $125,000 a year, and couples up to $200,000.

The value of the property that can be purchased under the scheme will also be limited by region, but the details of this are yet to be released.

But is this the best way for a first-home buyer to get a leg-up into the market? A government guarantor may be good for some, but there are a few factors to consider.

1. Getting in early comes with costs

Behavioural economics tells us that people have a tendency to pay more to get something sooner. Under the first-home buyer deposit scheme, a first-home buyer would be paying more over the life of the loan to get into the property market now.

Domain research suggests that average Sydney first-home buyers could save themselves almost four years and eight months by using a 5% deposit instead of a 20% deposit.

But the flip side of the enticing 5% deposit is that while it saves time, it costs substantially more. The figure below uses a set of assumptions of a typical mortgage for a first-home buyer purchasing an entry-level house. The scenarios use a 4.61% interest rate based on a 12-month average of the discounted-variable, owner-occupier rate from the RBA.

Mortgage scenarios under a 20% deposit, 5% deposit and the FHLDS

Based on a 20% deposit in this model, the total cost of a house and loan would be $793,102. The monthly mortgage repayments would be $2303. 

A 5% deposit where the first-home buyer has to pay LMI (i.e, does not have the first-home buyer deposit scheme or a loan guarantor) creates an added $78,000 owed over the loan. This is because the first-home buyer takes on higher debt, pays more interest and pays LMI. It also adds $516 a month to mortgage repayments.

Even where a first-home buyer takes advantage of the first-home buyer deposit scheme and does not pay LMI, the 5% scenario still creates an added $53,000 owed. This is because the main cost of a 5% deposit loan is all the interest accumulated of debt.

It’s also important to note that taking on more debt is risky. A 5% deposit goes against the more prudential culture that regulators have tried to cultivate in recent years.

As banking regulator APRA advised banks to limit risky mortgage exposure, banks partially did so by requiring higher deposit levels. Lending with at least a 20% deposit currently represents 79% of major bank mortgage lending. 

2. Interest is dead money, but so is rent

Interest may be considered “dead money” for a consumer in the same way rent is. So weighing up the costs of longer debt and larger interest repayments versus renting would also be a consideration.

The LMI-free loan scenario with a 5% deposit sees the typical first-home buyer spend an extra $53,000 on their home.

However, Domain rental data suggests that $53,000 would buy two years of rent for a typical apartment in Sydney. In that scenario, a first-home buyer may spend more on rent while trying to save a 20% deposit, than they would in the added interest, meaning it would be better to get into the market sooner.

In reality, however, asking rents for a whole house or unit may not reflect what individuals actually pay in rent.

Census data suggests group household compositions have increased in cities such as Sydney and Melbourne, as housing and rental costs rose between 2011 and 2016. In Sydney, group households increased 18%in this period, compared with total household increases of 7%.

Further, some first-home buyers may boost their savings rate and minimise rental costs by living with parents before buying their first home.

Given that there are methods to minimise rental costs while saving for a home, the 20% deposit could still be the best scenario for first-home buyers in the long run.

3. Capital gains count

Lower deposits generally mean more has to be paid off on the life of a mortgage.

But if capital growth is high for a long period of time, there may also be a benefit to being “in the market” sooner. This is especially useful where the property is held long term. The 26-year Domain stratified median price series shows capital city markets have delivered strong annualised returns.

Houses have typically grown 6.5% a year, and unit 5.7%. A homeowner with a low deposit could exceed the added mortgage costs with high capital growth. Another way to think about capital growth and the need to enter a market quickly is if property price growth outpaces savings.

Comparison site Canstar demonstrated that under certain growth conditions, the cost of buying a house could be just as high if not higher for those saving a 20% deposit if prices have grown significantly by the time the deposit is accumulated.

However, the flip side of this is that capital cities are currently seeing a decline in property prices (though experts are starting to call the trough of the cycle).

But as long as prices are falling, more time saving would see first-home buyers with a higher deposit and a lower entry price. Until prices start rising significantly, the current government proposal is far less relevant in helping first-home buyers.

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Disclaimer: This is general information only and should not be taken as financial advice. Please speak to a Shore financial planning professional before making a decision on your home loan. Originally sourced from an article 'First Home Loan Deposit Scheme: The 3 things buyers need to know before applying for a 5% deposit' by Eliza Owen.