March 6, 2017

How to Save for a House


Real estate is an investment. However, it is a different type of investment than say, retirement savings. You need liquid assets for a down payment. Depending on your timeframe, you may not have time to wait for dividends or rising stock prices. Knowing this, you need simple - yet effective - ways to save liquid funds.

Striving to save at least 20% for a down payment is the golden rule. On a $200,000 home, this means $40,000.

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That is not pocket change. You need an actionable plan to reach this lofty goal. 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 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.

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)

Know How Much House You Can 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.

Figure Out What Down Payment You Can 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.

TIPS YOU CAN USE

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?

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.

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.

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. First, 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 each month. Next, 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 excessive cable bills, phone plans, or grocery bills either. Evaluate your budget to see where you can cut.

  2. Determine where you will save. Saving money should not take effort. Online accounts are often the easiest because you transfer funds electronically. 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. You can do it right from your paycheck or from your checking account. You set the frequency and the rest of the work is done for you.

  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 Considerations for Down Payment Savings

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.

    At CreditDonkey, 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. 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. They also 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.

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:


How Much House Can I Afford


How Much Money Do You Need to Buy a House


Pre Approval Mortgage

More Articles in Money Tips


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May
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