March 6, 2017

How to Save for a House


Saving for a house down payment takes discipline. Here are smart tips on how to save such a large amount, including best ways to save for a house.

© CreditDonkey

If you're thinking of buying a house, one of the first thoughts in your head is probably:

"How do I save money to buy a house?"

You need an actionable plan to reach this goal. It is not pocket change. Striving to save at least 20% for a down payment is the golden rule. On a $200,000 home, this means $40,000.

Watch Out: There are loan programs that allow smaller down payments, but they cost more in the long run. If you put less than 20% down, you will pay Private Mortgage Insurance (PMI). PMI can cost as much as 1% of the loan amount per year. On the $200,000 loan, PMI could cost you $2,000 for insurance per year. This means an extra $166.67 on each mortgage payment.

What Is Your Timeframe?

Before you start saving, consider your timeframe. Do you want to purchase a house in the next year, 5 years, or 10 years?

Longer timeframes allow for smaller savings per year. For example, if you need a $40,000 down payment in 5 years, you must save $8,000 per year. If you need the same down payment in 10 years, you only need $4,000 per year.

Your goal for down payment savings is to avoid PMI. Keep in mind, you also need money for closing costs and an emergency fund. There is no better time to start saving than now.

What Is a Down Payment?

A seller receives money from two places at the closing - your down payment and the funds from your mortgage. Lenders reference the down payment as a percentage. A 20% down payment means 20% of the purchase price of the home. The remaining funds you need to purchase the home come from your mortgage.

As in the above example, let's say you purchase a $200,000 home. If the lender requires a 20% down payment, you would calculate it as follows:

$200,000 (sales price) x 0.20 (down payment) = $40,000 (down payment)
$200,000 (sales price) - $40,000 (down payment) = $160,000 (loan)

How Much House Can You Afford?

Before you start saving, it helps to know how much you need. If you will purchase a home in the next few years, you can use today's income to determine what you can afford. If your income increases, you only better your ability to pay the mortgage. You do not have to stick to this number when you actually purchase a home, though. If life causes your budget to change, then you accommodate accordingly. It does help give you a concrete figure to focus on right now, though.

In our article, How Much House Can I Afford, we go into detail about how to figure out what you can afford.

To sum it up, we recommend spending no more than 28% of your gross monthly income on your mortgage payment.

For example, if you make $75,000 per year, you would calculate the following:

$75,000/12 (months) = $6,256 (monthly income)
$6,256 x 0.28 = $1,752 (maximum total monthly mortgage payment)

If you estimate property taxes for your area at around $5,000 and annual homeowner's insurance at $950:

$5,000/12 (months) = $417 (monthly taxes)
$950/12 (months) = $79 (monthly insurance)
$1,752 - $417 (taxes) - $79 (insurance) = $1,256 per month for principal and interest (mortgage payment)

Assuming a 5% interest rate, you can estimate your mortgage payment to be $550 for every $100,000 you borrow.

$1,256/$550 = 2.28
$100,000 x 2.28 = $228,000 mortgage

Once you know this amount, you can determine how much you want to save. This will give you the total amount of house you can afford. If you can save 20% in this example, you could purchase a $275,000 home with a $55,000 down payment.

How Much Cash Do You Actually Need?

To buy a home, you will need cash for your earnest money, your down payment, your closing costs, and some additional items such as a home inspection, application fee, and credit check. You may be able to fold your closing costs into your loan, but you may find in doing so that you have a higher overall monthly payment.

  • Earnest money is deposited in escrow with the initial written offer. It is applied to the down payment. If your offer is not accepted, the earnest money is returned to you. It is generally a small percentage of the purchase price, or a flat amount of $1000 and up depending on your market.

  • The home inspection is vital for most home buyers. It costs several hundred dollars, and will tell you if there are problems with the home that are not apparent to the untrained eye. You may also want to pay for a separate termite inspection.

  • Lender fees may also be a small percentage of the loan, to cover costs such as inspections, appraisals, credit checks, and processing the loan. Usually the application fee is a few hundred dollars. Other fees are usually due at closing and depending on the loan, may be folded into the mortgage.

Other costs to consider are taxes that would be held in escrow, and HOA fees paid upon ownership of the property.

How Much Down Payment Can You Afford?

The standard throughout the mortgage industry is a 20% down payment.

However, it does not mean you have to put that much down. Your timeframe and ability to save determine how much you can save. There are programs that allow smaller down payments. However, when you figure your monthly mortgage payment, you must include mortgage insurance. This takes away from how much house you can afford.

Low Down Payment Options

There are several loan programs offering lower down payment options, including conforming loans:

  • Fannie Mae offers a 3% down payment program
  • FHA loans require only 3.5% down
  • VA loans do not require any money down
  • USDA loans also do not require a down payment

For more information on these loan options, visit our article titled How Much Money Do You Need to Buy a House?

Mortgage Insurance

If you do not put 20% down on the home, you will pay mortgage insurance for many programs. The only exception is the VA loan. Only veterans qualify for this loan program, though.

Tip: With conventional financing, you can cancel the PMI once you owe less than 80% of the value of your home. You can make this happen in two ways:

  • Wait until you make enough payments to hit below an 80% LTV
  • Refinance after you know your home appreciated and you owe less than 80% of the appreciated value

FHA and USDA loans require mortgage insurance for the life of the loan. You can refinance out of the insurance in the future if you qualify for a conforming loan.

Mortgage Rates

Mortgage rates are an important factor in how much house you can afford. Buying a house is not just the down payment and closing costs - you'll have a mortgage to pay as a homeowner, along with taxes and routine expenses such as utilities and additional maintenance costs.

Mortgage rates can vary, depending on the term of the loan, the amount, and your credit score. It pays to shop for the best rate, but also pay attention to realistic disclosures along with advertisements of low rates. Consult with a mortgage professional to see what loans and rates may be available to you.

Steps to Save for a Home

Now you know how much you need to save, but you need the steps to save it. A few dollars saved occasionally will not cut it. Instead, you need proper steps in place.

  1. Create a plan. Consistency is the key to saving for a down payment.

    1. Figure out what you can afford. Look at your gross monthly income and current monthly obligations. Don't forget about daily living expenses. You need an accurate picture of the money that comes in and goes out.

    2. Consider if you can change any of those expenses. Do you have habits you can stop in order to save money each month? Common areas on which people spend excessively include coffee stops, fast food runs, and shopping. Don't overlook cable bills, phone plans, or grocery bills either. Evaluate your budget to see where you can cut.

    Tip: Your spending habits can really affect your ability to save money, and often you are spending money without realizing what it does to your overall budget and savings plan. How much money would you save if you made coffee at home instead of stopping at a food truck or Starbucks before work? Add it up!

    The same principle applies to eating in restaurants or fast food places. Do you bring lunch from home, or do you order takeout or stop at the local sandwich shop for lunch? Add it up! The savings can be enlightening.

    Evaluate your utilities, your phone plans, your internet plans. Are there new options available? Do you need the latest and greatest smartphone, and the charge for data that goes with it?

    Another spending habit to evaluate is how much you spend on cigarettes, beer, and wine. We're not going to lecture you about your physical health and smoking, but your financial health takes a hit, both in the cost of the cigarettes and your overall health. Consider overall what you want to spend on liquor if you drink.

  2. Determine where you will save. Saving money should not take effort. Online savings accounts are often the easiest because you transfer funds electronically.

    Note: Don't make the mistake of opening a savings account 3 towns over that you cannot easily access. You want your money somewhere that you can easily stop to deposit the funds or electronically transfer. Credit unions and your current bank are great places to start. If you have to work too hard to get the money into your savings account, it probably won't happen.

  3. Set up automatic savings. Through your employer or your bank, you can set up an automatic savings plan. You determine the amount and schedule automatic deposits into your savings account or a long term savings account, such as a money market or certificate of deposit (CD). These tend to have higher interest rates than regular savings. But there are penalties for early withdrawal.

  4. Save your bonus money. This could mean actual bonuses from work or commissions. It also includes gifts for holidays or birthdays, tax refunds, or money you make from selling personal items. Any extra money outside of your regular income is bonus money. Immediately place this money in your savings account.

Other Sources for Down Payment Money

Sometimes down payment funds do not come directly from your own paycheck. There are a few other options - an IRA withdrawal, down payment assistance, and gift funds from friends or relatives.

  • IRA Withdrawal
    The IRS allows you to borrow from your IRA or Roth IRA one time. This is only for first-time homebuyers. You can withdraw up to $10,000 without penalty to purchase your first home. This amount is per person; if you are married, your spouse can withdraw $10,000 as well. There are a few distinct rules the IRA and Roth IRA have:

    • Traditional IRA withdrawals require the payment of income taxes. You never paid the taxes on this money (as your employer deducts it before taxes). You do not pay the 10% penalty, but keep the tax liability in mind for tax season.
    • You must hold a Roth IRA account for at least 5 years before you can withdraw the $10,000. You do not owe taxes on this money, though. You already paid it since Roth IRA funds are already taxed funds.

    Note: We do not necessarily recommend withdrawing funds from your retirement account. If you need to use it as a strategy, make it a last resort. Try to be creative and use the above strategies to ensure you have enough money for the down payment. If you need to borrow from your IRA, always talk to your tax professional first. He can help you decide if borrowing from your IRA is right based on the current market trends.

  • Down Payment Assistance Programs
    First-time homebuyers do have access to several hundred down payment assistance programs. The terms of the programs differ based on who provides the funds. You may receive a grant, which does not require repayment or have access to lower interest rates.

    Tip: There are also programs, such as the USDA and VA loans, that do not require any down payment. However, you have to meet specific requirements for eligibility with these programs.

    • Only veterans or their surviving spouses are eligible for a VA loan
    • For a USDA loan, you must purchase a home in a rural area and make less than 115% of the average income for the area

  • Gifts from Family or Friends
    Many loan programs allow you to incorporate gift funds with your own money for a down payment. Before you accept a gift, though, make sure you talk to your loan officer. Each program has different requirements on how much you can receive.

    Note: You need the funds handled in a specific way. You cannot just take cash and deposit it in your bank account. The donor must provide a Gift Letter. It must state the date, amount of the funds and the reason for the gift. It should also state that it is a gift rather than a loan. The lender must track the funds throughout the transaction. This includes when the donor withdraws the funds and when you deposit them. The larger the paper trail, the more likely it is the lender will approve use of the gift funds.

How Does Your Credit Score Figure Into Buying a Home?

Your credit score is an important factor when you apply for a mortgage. Lenders look at your credit history, your ability to pay your debts, your history of late payments, and your overall indebtedness. A low credit score may not keep you from getting a mortgage, but it will impact the choices that you have. You may find yourself not eligible for the best loans for your situation.

Tip: A high amount of credit card debt hurts you out in two ways - you are paying additional money each month in fees and interest, and you are also lowering your credit score, which affects your qualification for a mortgage.

If you have a high amount of credit card debt with a high interest rate, it might be a good choice for you to consider a balance transfer to a card with lower interest. If you continue to make the same payments on the new balance with a lower interest rate, you will be able to pay down the debt faster.

Related: How to Improve Your Credit Score

Smart Strategies to Save for a House

  • While Renting
    Yes, it may seem that you are throwing money away on rent, but in fact you are showing that you can meet a monthly payment. Try to ensure that your rent does not take more out of your pocket each month than you can afford.

    Rent to Own: Some people are able to rent a home with an option to buy. This can be a good strategy for you if you really like where you are living, if your credit score is weak and you need time to improve it, or if you cannot get a mortgage now but will be able to in the future.

    When a tenant wishes to enter into a rent to own agreement, they put money down for an option - a one-time fee which is not usually refundable. They have the option to purchase the property at some future point. They are not obligated to purchase. If the buyer cannot purchase the property at the end of the option, the fee is forfeited unless there is an agreement that it is refundable. The option can range between 2.5% and 7% of the purchase price. The agreement may specify that option money may be applied to the sale price at the close of the sale.

    Often a percentage of the rent is applied to the purchase price, as specified in the lease contract. Buyers should consult with a real estate attorney before entering into a rent to own agreement.

  • To buy a house in 6 months

    1. Temporarily increase your income with a second part time job or working overtime.

    2. Cut your expenses by saying no to impulse buys, cutting out entertainment and unnecessary expenses, and shopping for the best price on groceries and clothing. Coupons and online rebate deals help for purchases you must make for necessities.

    3. Set up automatic savings.

    Get a Second Job: Here are a few ideas for temporarily boosting your income with a second job:

    • Driving for Uber or Lyft
    • Online writing services - companies sometimes need writers to curate existing articles, edit their web content, or write small articles.
    • Tutoring. You can do this in person through a school or agency, or you can do it online.
    • Seasonal jobs. Not only departments stores at Christmas, but perhaps additional assistance is needed during warm months at the beach.
    • Restaurants often need good help. They tend to pay low, but with tips you can often do very well.

  • To buy a house in 5 years
    All of the above - plus build flexibility in your savings plan. Your needs will fluctuate over time. It's important to bank windfalls, such as gifts, bonuses, or large commission checks. Don't forget to plan for emergencies - you need a financial cushion to keep current with expenses in case of a sudden illness or layoff.

    If you can commit to saving several thousand dollars a year over several years, you will see that your down payment savings build up and you may be able to shorten the time you need to save for the down payment and expenses.

  • To buy a house on a low income
    There are mortgage programs for people with low income and good credit. Freddie Mac offers Home Possible Advantage, and Fannie Mae offers HomeReady. These feature low down payments and the ability to count non-borrower income or boarder income. There are also education requirements from an approved provider.

    There are additional programs listed on the HUD website, enabling teachers, first responders, and nurses to buy HUD foreclosure homes at a 50 percent discount. With an FHA mortgage, the down payment is minimal. A licensed real estate agent must put in the offer for you.

    If you have a low income, it is well worth your while to research these loan programs, which can be more flexible on sources of income requirements. But you also need to save for the down payment and closing fees.

    You may qualify for down payment assistance offered by charities, employers, and government agencies. Many who qualify for down payment assistance do not receive it, because they do not know that it is available.

Where to Save Your Money

Saving for a down payment is a short-term process. Even if you start 5 to 7 years before you purchase a home, it is still a short amount of time.

When you invest for long-term things, like retirement, you have more ability to take a risk. If you invest in the stock market and lose it, you may have 30 or more years to make it up. You need down payment money, however, much sooner than the next 30 years. You need to invest it in places where you can access it and where you won't lose money.

We suggest savings accounts, CDs or money markets, depending on your timeframe. All other investment vehicles pose too much risk and could bring your dreams for a home crashing down.

Bottom Line

The earlier you start saving for a home, the better. Aiming for a 20% down payment will help you minimize the extra fees on your future mortgage payment. It may also help you secure a lower interest rate. Lenders look at lower loan-to-value ratios as less risky. The more you borrow, the riskier you look. Lenders adjust your interest rate accordingly.

We recommend that you start putting plans in place today to start saving for a home. Even if you won't purchase a home for the next few years, saving now saves you money later.

More from CreditDonkey:


Buying Your First Home


How Much House Can I Afford


How Much Money Do You Need to Buy a House

More Articles in Money Tips


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December
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2017

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