How to Save on a Down Payment on a Home
Your home is probably the most expensive thing you will ever buy. Saving tens of thousands on your down payment may seem darn impossible, but with a little planning, you can make it happen.
In some cases, you cannot afford to buy a home, and that’s okay. There is nothing shameful about renting. But if you have calculated, and the purchase is quite feasible, then the first step is to accumulate funds for a down payment.
Calculate how much you need to save
A common myth that buying a home is always a smart financial decision . People think that renting does not lead to ownership; it is a waste of money. But depending on where you live, you can save more money over time by renting out. You just have to seriously iterate over the numbers to figure out what’s best for you. The New York Times has the best rental and buying tool I’ve ever seen . It takes all the numbers into account and tells you at what price buying becomes a smarter financial decision than renting.
You want to get a general idea of how much home you can afford. There are many home affordability calculators out there, but most are based on how much down payment you already have, and we’ll assume you’re starting from scratch. Even if so, you can play around with these calculators , try different numbers, and get an idea of how much home you can buy with different down payment scenarios.
We recommend reducing (or at least saving) the standard 20 percent . Even if you do not specify this full percentage, it is wise to save so much so that you have a buffer. Always save more than you need in case of any maintenance issue or emergency. If saving that amount seems like a pipe dream, you might consider buying a less expensive home or wait longer to save. If you invest less than 20 percent (some loans only allow you to deposit 3 percent), keep in mind that you will pay more in interest and you will also have to pay your monthly mortgage insurance.
Of course, the affordability of a home isn’t just a down payment. When the lender approves the mortgage amount for you, he is interested in three things:
- Down payment : It’s obvious how much money you put on your home.
- Initial Income Ratio : The percentage of your annual gross income that goes towards paying off your mortgage (including principal, interest, taxes, and insurance).
- Internal Ratio : The percentage of your annual gross income that goes towards paying off other debt.
When you figure out how much you can afford, you will need to consider these factors as well. As a rule of thumb: your frontend ratio should not exceed 28 percent. This means that you should not spend more than 28 percent of your monthly income on paying for housing. Again, you can use a handy mortgage calculator to play with the numbers and see how much home you can afford based on this rule and different down payment scenarios. One final rule to start with: Many experts say your home shouldn’t be more than 2.5 times your annual gross salary.
These rules are not an exact science; they are simply intended to give you a rough idea of what you can afford and what your down payment should be. However, these are good rules to follow in order not to become poor at home .
Make a spending plan
Once you’ve decided on the amount of your down payment, it’s time to plan and get started. Look at your budget and find out how much you can afford to save each month. If you want to save as quickly as possible, that could mean cutting down on some areas of spending .
If you use a mint , they have a decent tool for planning your savings. Just add a new goal, enter the total amount, and then indicate how much you plan to save each month. Mint will tell you how quickly you can save to reach your goal and will automatically deduct that amount from your monthly budget. You can also check if some of the savings comes from other sources, such as interest.
We’re big fans of paying yourself first to make sure you reach your savings goals. When you get paid, set aside a certain percentage of your savings. Or better yet, make it automatic and set up a monthly transfer at your bank.
Decide where to leave your savings
You may well be able to keep your down payment in a traditional savings account. It won’t generate much interest, but it will be liquid, which means you have easy access to it. If you are planning to buy in the next year or two, this is probably your best bet.
But if your timeline is a little behind, you may want to consider some other options .
A Certificate of Deposit (CD) is great if your maturity is three years or less. Your money is kept on CD for a certain amount of time (months to years) and you cannot access it without paying a fine. In return, the bank offers what they consider to be a “high” interest rate. Today’s rates are kind of a joke, but you can make a little more than a traditional savings account and your money is still safe and FDIC insured .
If your time frame is three to five years, you might consider investing them, but in something safe. The New York Times Bucks blog recommends “consider using short-term, high-quality no-load bonds.” These are investments with low risk and low return (for example, the Fidelity Bond Fund – FBIDX). Online brokerage firms like Fidelity, Vanguard or E * Trade can help you create an account. If you don’t think you’ll buy another five years or more, you may want to consider investing in a broad index or mutual funds . For this purpose, Vanguard offers its own LifeStrategy funds . Each fund is designed with a specific time frame and risk in mind.
You can also save money in your Individual Retirement Account (IRA). First-time home buyers can withdraw up to $ 10,000 from a traditional IRA to cover the cost of buying a home, including a down payment. And if you have a Roth IRA, you can withdraw any contributions (not earnings) you have made, without penalty, whenever you want. It is generally not recommended to borrow after retirement, but if you are just using it as a hiding place for a down payment on a home, it is a little different.
Improve your credit score
If your credit score is low, one way to lower your overall mortgage cost is to improve your credit . A higher score can give you a higher rate, and it can make a huge difference in how much you pay as interest. As Bankrate points out , at an interest rate of 4%, you would pay about $ 950 per month. With 5%, that’s $ 1,075 a month. Consider an extra $ 100 per month over time and you will pay a little more.
You should work on paying off the debt first, especially since your lender takes this into account when calculating your mortgage offers. It also makes financial sense to pay off any debt before you take on a large debt. And, of course, your credit will improve, which will give you a higher interest rate.
You should also make sure not to close any old credit cards before buying a home, because this lowers your credit limit, which in turn increases the use of your debt : the amount of your debt versus your total credit limit. This affects your credit score. Obviously, you also have to pay all bills on time. If you are going to pay off old debts, do it carefully . There are many scammers out there, sometimes they won’t even update your credit report, and the forgiven amount of debt can be taxed .
Handle large cash gifts correctly
Your grandmother wants to make you $ 5,000 in down payment on your house. Thank you grandma! Sounds simple enough, but it can be a big headache in the underwriting process (when a lender checks your paperwork to qualify you for a mortgage). If you’re ready, everything will be fine.
This is a headache because the underwriters want to make sure the money in your bank accounts belongs to you. As far as they know, $ 5,000 may be a loan that you have to repay and that makes you more risky. Therefore, if a family member wants to make a cash gift, ask him to write a letter. According to Quicken Loans , this letter should include:
- Donor’s name, address and telephone number.
- Donor-client relationship
- Gift amount in dollars
- Transfer date
- Donor’s statement that no refund is expected
- Donor’s signature
- Address of the acquired property
If you are going to get an FHA loan, the donor will also need to provide some bank statements.
There are also rules about how much of this gift you can spend on a loan. With a regular loan, you can use all this money to make your down payment, provided that you deposit 20% or more. if you deposit less than 20%, only part of the down payment can be a gift and the amount you are allowed to use depends on the loan. if you have an FHA or VA loan, the entire down payment may be gift-giving. But if your credit score is low, at least 3.5% of your down payment should be paid out of your own pocket.
Buying a home is fun, but also incredibly expensive. With some planning and realistic budgeting, you can start saving and hopefully come up with a time frame to get you into the home you like.