If buying a new home is part of your New Year’s resolution for 2019, you need to understand how the down payment will affect you. Your down payment is a crucial part of submitting an offer on a home. Historic City News readers are invited to learn exactly what a down payment is and how to start saving today to accomplish what is typically the single largest business transaction of your life.
Before you can be approved for a mortgage, you’ll need a down payment. Conventional wisdom suggests paying 20% of a home’s purchase price in cash upfront – known as the down payment. Your mortgage finances the remaining 80% of the purchase price.
While 20% might not seem like a lot of money if you’re buying a new car, it can be a large amount to come out of your bank account at once: $50,000 for a home priced at $250,000, $70,000 for a house that sells for $350,000, and a full $100,000 if you buy a $500,000 property.
Many of us don’t have that amount saved in our invested retirement accounts, much less sitting around in a savings account in cash. So how will you get enough money for a down payment on your dream home?
How to Save For a Down Payment
Calculate how much and how quickly you want to save.
Consider the price of the house you can afford and determine 20% of the value. That’s your target. Let’s say it’s $50,000. Divide that number by your time horizon. If you want to buy in five years, divide by five — you’ll need to save $10,000 per year. Divide that number by 12, and you’ll get your target monthly savings goal: $834.
Simple, right? Yes, but not necessarily easy. Perhaps you want to buy a home sooner. You can shorten your time horizon by saving more each month, but that may not be possible with your current budget. Or maybe $834 per month for five years just isn’t doable at all. Either way, there’s good news: People get enough money for a down payment through a number of different methods.
Start small to save big.
Even small contributions add up over time, so be vigilant about looking for ways to cut costs or save more — and shift that cash to your down payment fund right away. Simple approaches, like downgrading your cable package or cell phone service, can offer a monthly savings boost. But if you’re hoping for a more aggressive timeline, consider bolder changes like moving in with a family member to save on rent or ditching your car for public transportation.
Invest your dollars instead of saving them.
If you don’t plan to buy a home within the next five years, consider putting your money to work for you. That means going from saving in cash to investing in the market. Compound interest allows you to exponentially increase the value of your initial contributions. Let’s say you invested $1,000 in a brokerage account today with the intention of buying a home in seven years. Going forward, you contribute $500 per month to your account and earn an average return of 6%. After seven years, you’d have enough money for a big down payment — $51,866.66, to be exact.
Compare this with putting your cash in a savings account with a high yield of 1%. Over the same seven-year period, contributing $500 per month, you’d have only $44,353.35 — or $7,500 less.
Warning: You only want to invest your down payment cash if you can handle the risk of losing some (or, worst case, all) of it. You can’t enjoy returns without risk, and no investment is guaranteed to make money. That’s why it’s important to have a longer time horizon; it gives you a chance to ride out market volatility and can decrease the chance of disrupting your financial goals.
Share your down payment goal with friends and family.
Ever contributed to a cool new business idea on Kickstarter? What if you could create something similar but for others to help you fund your down payment? It’s possible! (Not on Kickstarter, though, since personal campaigns aren’t allowed there.) Sites like GoFundMe allow you to set up a campaign for any reason and then share it with your social networks. Anyone can contribute if they feel compelled by your cause. Crowdfunding your real estate purchase can help you raise money — and your extended network or even total strangers can pitch in to support you.
If it feels weird to ask for money outright, you can still gather funds from friends and family without asking them to spend more than they normally would on you. Share your down payment goal with people you normally swap presents with (for birthdays, holidays, and other special occasions) and request they hold off on material goods and give cash until you fund your goal. Explain that any gift money you receive will go straight toward your down payment so you can buy a home. They’ll probably appreciate that you shared your big goal with them and will be happy to know their gift is truly wanted and valued.
Dip into your nest egg.
This suggestion comes with a big word of caution: Pulling money from a retirement account for a down payment shouldn’t be your first choice. To get the most from your retirement savings, you need to contribute to accounts like your 401(k) and Roth IRA and leave that money alone until you actually retire. But there are exceptions to every rule, and it may make sense to pull from a retirement account to get enough money for a down payment.
You can withdraw your contributions from a Roth IRA at any time without penalty or tax. You can also take out up to $10,000 of earnings without any kind of penalty if you’ve had the account for at least five years and use the funds to purchase or repair your first home. You can withdraw up to $10,000 from your traditional, SIMPLE, or SEP IRA too, but you will need to pay regular income tax on the amount you take. As long as you use the funds to purchase or repair your first home, you won’t be penalized on top of the tax.
Lastly, you can take out money from a 401(k) too, but this is considered a loan against your retirement account — and you’ll have to repay it. That loan also counts as debt, which could skew your debt-to-income ratio. Lenders look at that metric to determine whether you qualify for a mortgage, so be careful before going this route.
Talk to an objective, knowledgeable third party about retirement withdrawals before you dip into any part of your nest egg. Someone like a fee-only certified financial planner will understand the ins and outs of taking money from retirement accounts and can inform you of all the potential consequences to help you weigh your options and make the best decision for how to save for a down payment.
Consider putting less money down.
Despite common beliefs, a 20% down payment is not a requirement for homeownership. Sure, there are a ton of reasons why it’s best to put 20% down on your house. For starters, it’ll help you avoid paying PMI (private mortgage insurance), it can make your offer look stronger, it’ll help you pay less interest over the life of your loan, and it could even help you get a lower interest rate.
But in reality, only 37% of first-time buyers in 2017 put down 20% or more. The rest of us? Luckily there are home loan options out there that allow for smaller down payments. Conventional loans allow for down payments as low as 3%. But remember, you’ll also be required to pay PMI since you’re putting less than 20% down. Government programs like FHA loans and VA loans allow for down payments of 3.5% and 0%, respectively. But there’s a catch – FHA loans require an upfront and monthly mortgage insurance premium (MIP), and VA loans require a VA funding fee, in most cases.
Again, there are many benefits to putting 20% down on your home. So stay focused on your savings goals. But if you’d like to buy sooner than you can save up the full amount, talk to a mortgage professional to discover your lower down payment options.