Your home is probably the most expensive thing you'll ever buy. Saving up tens of thousands for a down payment can seem damn near impossible, but with a little planning, you can make it happen. Illustration by Fruzsina Kuhári.
In some cases, you may not be able to afford to buy a home, and that's OK. There's no shame in renting. But if you've crunched the numbers, and buying is doable, saving up for a down payment is the first step.
Calculate How Much You Need to Save
It's a common myth that buying a home is always a smart financial decision. People assume, because renting doesn't lead to owning anything, it's a waste of money. But depending on where you live, you can actually save more money over time by renting. You just have to do some serious number-crunching to figure out which is best for you. The New York Times has the best rent vs buy tool I've seen. It factors in all of the numbers and tells you at what price point buying becomes a smarter financial decision than renting.
You want to get a general idea of how much home you can afford. There are a lot of home affordability calculators out there, but most of them are based on how big of a down payment you already have, and we're assuming you're starting from zero. Even if you are, you can play with these calculators, try out various numbers and get an idea of how much house you can buy with different down payment scenarios.
We recommend putting down (or at least saving) the standard 20 per cent. Even if you don't put down that full percentage, it's smart to save that much so you have a buffer. Always save more than you need for any maintenance issues or emergencies. If saving that much seems like an impossible dream, you might want to consider buying a less expensive home or waiting longer to save. If you do put down less than 20 per cent (some loans let you put down as little as 3 per cent), keep in mind, you'll pay more in interest and you'll also have to pay monthly mortgage insurance.
Of course, home affordability isn't just about a down payment. When a lender approves you for a mortgage amount, they're interested in three things:
- Down Payment: Obviously, how much money you're putting down on the house.
- Front-End Ratio: The per cent of your annual gross income that goes toward paying your mortgage (including principal, interest, taxes and insurance).
- Back-End Ratio: The per cent of your annual gross income that goes toward paying other debt.
When you figure out how much you can afford, you'll want to consider those factors, too. As a general rule: your front-end ratio should be no more than 28 per cent. That means you shouldn't spend more than 28 per cent of your monthly income on housing costs. Again, you can use a handy mortgage calculator to play around with the numbers and see how much home you can afford based on that rule and considering various down payment scenarios. One final rule to get you started: many experts say your home should be no more than 2.5 times your gross annual salary.
These rules aren't an exact science; they're just meant to get you in the ballpark of what you can afford, and what your down payment should be. However, they're good rules to follow to avoid being house poor.
Create a Spending Plan
Once you've decided on your down payment amount, it's time to come up with a plan and get started. Look at your budget and figure out how much you can afford to save each month. If you want to save up as quickly as possible, that might mean cutting back on some spending areas.
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 in your savings. Or better yet, make it automatic and set up a monthly transfer at your bank.
Decide Where to Park Your Savings
You can very well save your down payment in a traditional savings account. It won't garner much interest, but it will be liquid, meaning you have easy access to it. If you're planning to buy within the next year or two, this is probably your best bet.
But if your time frame is a little further out, you might consider some other options.
A term deposit is great if your time frame is three years or less. Your money is kept in the term deposit for a certain amount of time (anywhere from a few months to years), and you can't access it without paying a penalty. In exchange, the bank offers what they deem a "high" interest rate. Today's rates are kind of a joke, but you can earn a tad more than you would in a traditional savings account, and your money is still safe.
If your time frame is anywhere between three and five years, you might consider investing it, but in something safe. The New York Times Bucks blog recommends "considering short-term, high-quality, no-load bond funds". Those are low risk, low return investments. An online brokerage firm like Fidelity, Vanguard or E*Trade can help you set up an account. If you don't think you'll buy for another five years or more, you might want to look into investing in some broad index or mutual funds. Vanguard offers their own LifeStrategy Funds for goals like this. Each fund is designed with a specific time frame and risk in mind.
Beef Up Your Credit Score
If your credit score isn't great, one way to cut your total mortgage cost is to work on improving your credit. A higher score can get you a better rate, and that can make a huge difference in how much you pay in interest. As Bankrate points out, with a 4 per cent interest rate, you'll pay about $950 a month. With 5 per cent, that adds up to $1075 a month. Consider an extra $100 a month over time, and you're paying quite a bit extra.
You want to work on paying down your debt first, especially because your lender considers that when calculating your mortgage offerings. It also just makes good financial sense to pay off any debt before you take on a massive one. And, of course, your credit will improve, giving you a better interest rate.
You also want to make sure not to close any old credit cards before buying a home, because that reduces your credit limit, which in turn increases your debt utilisation: the amount of debt you have versus your total credit limit. This affects your credit score. Obviously, you should also make sure to pay all bills on time. If you're going to settle old debts, do it carefully. There are a lot of scams out there, sometimes they don't even update your credit report, and the forgiven amount of debt can be taxable.
Handle Large Cash Gifts Properly
Your grandma wants to give you $5000 as a gift for your home down payment. Thanks, Grandma! Sounds simple enough, but it can be a big headache during the underwriting process (when the lender reviews your paperwork to qualify you for a mortgage). If you're prepared, it shouldn't be too bad.
It's a headache because the underwriters want to make sure the money in your bank accounts belongs to you. For all they know, that $5000 might be a loan that you have to pay back, and that makes you riskier. So if a family member wants to donate a cash gift, ask them to write a letter. According to Quicken Loans, this letter should include:
- The donor's name, address and phone number
- The donor's relationship to the client
- The dollar amount of the gift
- The date the funds were transferred
- A statement from the donor that no repayment is expected
- The donor's signature
- The address of the property being purchased
Buying a house is exciting, but it's also incredibly expensive. With some planning and realistic budgeting, you can start saving and hopefully come up with a time frame that puts you into a home you love.