Are you looking to buy a new house? You better start saving money for the down payment right away. A house is a big investment and you will need to save well to build up enough of a corpus to be able to afford a down payment for a house.
What is a Down Payment?
A down payment is the amount of cash that you have to bring to the table when you are in the process of buying a home. You may borrow money from the bank in the form of a home loan or mortgage, but a portion of the total cost must come directly from you. That portion is known as a down payment.
Why do you need to pay a Down Payment?
The down payment acts as an insurance of sorts for your lender. When you hand over money from your own account, you’re officially invested in the deal. You’re more likely to make good on your mortgage payments month after month and year after year. Banks like working with such customers. Since a good chunk of your money is already with the bank, the chances of you reneging from your deal are lower.
If you save up sufficiently for your down payment, you will enhance your credit rating and you will also be able to put your mind at ease. A good and sizeable down payment will reduce the amount of money you need to pay every month towards your house. It will also help you choose a short mortgage term so you can finish paying the monumental debt off quickly.
How much do I need to save for my down payment?
It’s no secret that we don’t like debt. That’s because car loans, student loans and credit card debt can tie up our income, leaving us with less money for the things we really want to do. It’s impossible to go on that European holiday when you are spending all your hard earned cash on paying off debts.
So how much should you save? That’s the million-dollar question. But don’t worry. You won’t need anything close to one million dollars to set yourself on the right track for buying a home (unless you want a multi million dollar mansion in Malibu). However, you do need to work through the process below to arrive at your magic number.
Let’s use an imaginary family, the Waynes to illustrate the situation.
Step 1: Determine how much you can afford each month. The rule of thumb is to spend no more than 25% of your monthly take-home pay on your mortgage payment. If you tie up too much of your budget in your monthly payment, you leave yourself unprepared for facing emergencies or embracing opportunities.
For the Waynes, 25% of their monthly take-home pay equals $1,050 each month. Keep in mind that this number should include taxes, insurance, escrow, and homeowner association fees. Write down how much money you (and your spouse, if applicable) bring home each month. Calculate your monthly mortgage amount by multiplying it with 0.25.
Step 2: Use your monthly mortgage payment to arrive at a total mortgage amount.
When it comes to the type of mortgage you select, a 15-year fixed rate is highly recommended, that plan is guaranteed to save you tens of thousands of dollars compared to the traditional 30-year option.
We know the Waynes have $1,050 to spend on their monthly mortgage payment. If the interest rate is set at 3.66% in a mortgage calculator, we discover that they can purchase a $145,000 home with a 20% down payment, a $130,000 home with a 15% down payment, or a $125,000 home with a 10% down payment.
Step 3: Aim for between 10% and 20% of the value of the house for your down payment. If you haven’t already, hone in on the percentage that works best for your family. Ideally, you’ll choose to put down 20%, which can lower your interest rate, open you up for a 15-year mortgage, and help you avoid private mortgage insurance (PMI).
Let’s assume the Waynes decide to put down 20% on a $145,000 home. That means they’ll need to set aside $29,000 for a down payment.
Multiply the total mortgage amount by the percentage you plan to put towards the purchase of a home. Now you’ve got your savings goal. Start saving up towards it.
What Other Costs Should I Consider When Saving for a Down Payment?
Private Mortgage Insurance (PMI)
PMI is a fee tacked on to your monthly mortgage payment if you put down less than 20% on your home. You can count on PMI increasing your monthly payment by about $50 for every $100,000 you spend on a home.
Appraisal and Inspection Fees
In order for your lender to sign off on your mortgage, you’ll need to have your future home appraised and inspected. Each of these can cost over $300 on average.
Closing Costs
A lot of work goes into signing on the dotted line. And unless the seller agrees to pick up the tab, you’ll be responsible for fees between 2% and 5% of the total mortgage value.
Our imaginary family, the Waynes, already plans to save $29,000 for a down payment of 15%. And now that they’re aware about the “hidden” fees of buying a home, they’ll need to set aside a bit more to cover them.
Here are the steps that the Waynes have to encounter:
- The Waynes purchase a $145,000 home with $21,750 down payment.
- Their mortgage amount equals $116,000.
- The cost to cover the first month’s PMI at closing is $65.
- An appraisal and inspection fees equals $600.
- Fees from closing costs could be as much as $5,800.
- In addition to the $21,750 down payment, the Waynes should set aside an additional $6,465.
- And, if the Waynes get lucky and the seller agrees to cover closing costs, that leaves them with a good amount of money to put to good use elsewhere.
How to Save for a Down Payment?
Start with a smaller number. Does that big, looming down payment goal overwhelm you? Split it up. Decide when you’d like to buy. How many months away is your goal date? Simply divide your needed down payment by the number of months you have to save.
Our imaginary Waynr family wants to save $34,465 to cover a down payment and all closing costs of purchasing a new home. They’d like to buy a home in two years, so they’ll need to save $1,478 each month to hit their goal.
If you do your calculations and find that your monthly savings amount is just too high, that’s okay. Give yourself a little more time to save up and be on the lookout for creative ways to save. Here are some suggestions:
Set up a Down Payment Fund
After you have calculated how much you need to save each month, create a fund for it, track your savings and reach your goals.
Start investing some extra money for your Down Payment Fund
Look for ways to trim your budget so you can put more toward your down payment. Here are a few ideas:
- Get rid of your cable connection.
- Start cooking and avoid takeaways.
- Cancel unused gym subscriptions.
- Do some overtime work.
- Start a side business.
- See if you can get a second job.
Don’t splurge your Down Payment savings away
There will come a time, probably about halfway to buying a home, that you might be tempted to take a spontaneous trip to Europe with your savings. Or you might want to buy that European luxury car. To protect yourself from yourself, don’t store your down payment money in your regular bank account. Try a separate savings account or a money market account instead. Ensure that no matter what the situation is (except for medical emergencies),you are not touching that money.