Affordability planning: how to save for a down payment
The down payment is a large sum of money that can act as a hurdle to many home buyers. By understanding the benefits of making a larger down payment and understanding how much you need to save, you can better set goals to ensure you are confidently buying at the right price point. Below we outline steps to set a plan to save and offer alternative down payment strategies.
Step 1: Know What to Save
When buying a home, you need to cover your down payment, closing costs, moving and refurnishing expenses, immediate repairs, and others, while retaining enough cash in your savings for emergencies. As common rule of thumb is that your housing expense should not exceed 28% of your monthly income. So if your monthly income is $10,000, you can comfortably allocate $2,800 to your future house payment — this includes more than just your mortgage payment, however. In addition to your mortgage payment (which is the principal and interest), you will be paying property taxes, insurance, and possibly homeowners association (HOA) dues.
You can use this mortgage calculator to determine to what mortgage loan amount that monthly payment roughly amount translates.
Note: This calculator does not include an emergency fund when generating recommended cash savings (bottom left) - we recommend also having three to six months of living expenses (mortgage payment + taxes & insurance + other monthly debts like credit cards or student loan payments + other spending such as groceries)
On top of that amount, you will need a down payment amount, which should generally fall between 10 and 20% of the home price. To determine that amount, take the mortgage amount and divide that figure by 0.8 and 0.9 and subtract the mortgage from that figure, this is your down payment estimation:
Down Payment / Percentage Down = Home Price
$50,000 / 0.20 = $250,000 Home Price
Home Price - Down Payment = Mortgage Amount
$250,000 - $50,000 = $200,000
Do not worry — your mortgage lender will be able to provide you these figures across different ranges to help create a baseline expectation.
In addition to the down payment, you will also need to cover closing costs, which can be up to 2% of the purchase price:
Closing Cost Estimate = 2% x $250,000 = $5,000
The last figure you’ll need to estimate is your emergency fund, which is the amount of cash you will retain after all is said and done. Generally, an emergency fund should be equivalent to three to six months of living expenses. Now that you have your estimated monthly housing payment, add to this any other monthly debt payments and spending (groceries, etc.) and multiply by 3 (or 6):
Three Monthly Emergency Fund = 3 x Monthly Living Expenses
3 x (Mortgage + Insurance + Taxes + Other Living Expenses + Other Debt Payments)
Down Payment + Closing Costs + Emergency Fund = Total Cash Needed
You have no arrived at the figure you need to save. Don’t forget to factor in any increases for household utilities like heat and electricity!
Step 2: Determine Your Timeline
By when do you want to buy? The average time is takes a buyer to find and close on a home is 12 weeks, but if can often take months of work by buyers to better understand their preferences and casually look for homes before engaging with a real estate agents. However much more you need to save, determine how many months that will take you so you can know when you are ready to start your home search in earnest.
Step 3: How To Save
Saving for a down payment is different than saving for retirement. Given the down payment money will be accessed sooner and serves a definite purpose, it makes more sense to save this money in a conventional savings account or boring investment vehicles like certificates of deposit. While investing in the stock market may help speed up the timeline, the risks involved may be more than you can bear. If, however, you have no definite timeline to purchase, investing in the stock market may make sense. You should consult with a financial advisor if you are unsure.
A great move is to set up an auto-savings plan. This means automatically setting aside more of your paycheck each month directly into a savings account.
Alternatives to Traditional Savings Plans for Down Payments
Put Less Down
While lenders have traditionally preferred a 20% down payment, there are other options available, especially to first-time buyers in the form of ‘nonconventional’ mortgage products (this differs from simply putting less down on a conventional, 30-year mortgage, for example).
The Federal Housing Administration and Department of Veterans Affairs back mortgage products that require as little as 3.5% down. However, buyers must pay mortgage insurance (which can be costly) throughout the life of the loan in order to compensate the lender. This differs from conventional loans where this insurance, known as Private Mortgage Insurance (PMI), expires when you reach 20% equity in your home (by making your monthly payments).
Family Gifts and Loans
While we wouldn’t recommend mixing family and money, a family gift may be an appealing way to raise the necessary funds for your home. A family loan, however, can be complicated as it is viewed as a repayable debt in the eyes of the lender and those will need to be considered in the borrower’s debt to income ratio and can work against a borrower when it comes to interest rate and mortgage availability.
Down Payment Assistance Programs
Historically, finding your way through your local state and federal down payment assistance programs can make the process not worth the effort. Thankfully, DownPaymentResource.com has consolidated these programs and made it available to lenders and brokers to help maximize your ability to buy a home.
These programs differ across state lines, but can be as targeted as neighborhood and blocks, and potentially house-by-house. These programs often designate homes into programs and are geared towards borrowers with lower income levels and geographic areas that need revitalization, but this is not always the case, hence making it worth your time to review. Be sure to ask your lender if not only you, but a potential listing you like qualifies for any of these programs.
As an extreme fallback option in most cases, borrowers can tap their existing retirement accounts to fund a down payment. While IRA accounts allow you to withdraw up to $10,000, this will trigger tax consequences for traditional IRAs and withdrawing money from your 401(k) incurs a 10% penalty on the withdrawal, in addition to the obvious negatives of taking money out of the stock market. Be sure to consult with a tax advisor or financial advisor before considering this strategy.
Pre-Approval vs Pre-Qualification and Why You Need It
Getting pre-approved means you have a conditional promise from form a lender they’ll support your offer (which sellers like). Having a pre-approval letter strengthens your offer as you, relative to others who have not yet secured financing, represent less risk a deal could fall apart. Here’s the difference between the two:
Low effort from the lender (less than 15 mins)
Financial Information and Credit not verified
A conditional promise to lend, subject to home evaluation
More thorough (24–48 hours)
Financial information and Credit is verified
Due to your pre-approval requiring a credit check, it is wise to limit the number of lenders with whom you seek a pre-approval letter as multiple credit checks can ding your credit score. However, credit companies are able to take into account that you are seeking a mortgage when your credit is checked in succession by similar lending institutions, so the effect is minimal in most instances.