How to Save Up for a Home Down Payment

Saving for a house

Your home is probably the most expensive thing you’ll ever buy. Saving up tens of thousands for a down payment can seem daunting, but with a little planning, you can make it happen.

In some cases, you may not be able to afford to buy a home, and that’s okay. 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.

Should I Buy a Home or Just Keep 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.

Follow the 20% Rule When Saving for a Down Payment on a Home

We recommend putting down (or at least saving) the standard 20 percent. 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 percent (some loans let you put down as little as 3%), 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 percent of your annual gross income that goes toward paying your mortgage (including principal, interest, taxes, and insurance).
Back-End Ratio: The percent 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 percent. That means you shouldn’t spend more than 28 percent 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.

Avoid Being “House Poor” By Learning to Be Patient

You may not have heard of the term “house poor” but you probably know what it means. The family that owns a 3 bedroom house, but can’t afford to pay their credit card bill. There’s a difference between being poor and being “house poor.” And it’s possible to avoid with a little patience.

Being “house poor” is something that happens over time. When you’re living paycheck to paycheck, not because you don’t have a better option, but because you choose a lifestyle that’s more expensive than the one you can actually afford. The solution to avoid this is dead simple: employ a little patience.

Becoming house poor doesn’t happen overnight, rather it happens month over month after moving into your home or when situations arise that you are unable to cope with financially.

Lifestyle inflation is a hard thing to avoid, but it’s key to financial health. While it may be hard to live in a smaller house than you really want while you save up, patience can keep you financially solvent while you work towards your dream.

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.

If you’re a Mint user, they have a decent tool for budgeting out your savings goals. Simply add a new goal, enter in the total amount, and then plug in how much you plan to save each month. Mint will tell you how quickly you can save up for the goal, and it will automatically deduct that amount from your monthly budget. You can also note if some of the savings comes from other sources, like interest.

How to Save Up for a Home Down Payment

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.

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.

The Best Place to Park Your Money, Based on Your Savings Goal

A Certificate of Deposit (CD) is great if your time frame is three years or less. Your money is kept in the CD 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 and FDIC-insured.

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 (Fidelity’s bond fund is FBIDX, for example). 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.

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 for homebuying expenses, which includes a down payment. And if you have a Roth IRA, you can take out any contributions (not earnings) you’ve made, penalty-free, whenever you want. It’s typically not recommended to borrow from your retirement, but if you’re just using it as a shelter for your home down payment, that’s a little different.

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. With a 4% interest rate, you’ll pay about $950 a month. With 5%, that adds up to $1,075 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 utilization: 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. Don’t forget to consider student loan debt. 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 $25,000 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. A rule of thumb: put the funds into your account as early as possible.

Underwriters want to make sure the money in your bank accounts belongs to you. For all they know, that $25,000 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. 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

If you’re going for an FHA loan, the donor will be required to show some supporting bank statements, too.

There are also rules about how much of this gift you can use toward your loan. With a conventional loan you can use all of that money to fund your down payment, provided you put down 20% or more. if you put down less than 20%, only part of the down payment can be a gift, and the amount you’re allowed to use varies depending on the loan. if you have an FHA or VA loan, all of the down payment can be gift money. But if your credit score is on the low side, at least 3.5% of your down payment has to come out of your own pocket.

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.