Saving for a Down Payment on a Home
The average American household has between $7,000 and $10,000 in savings. The younger they are, the less they have. For parents under the age of 34, it’s around $4,500 and for couples without children, it’s closer to $2,500. This may seem like a lot if you’re saving for a holiday but many of those young families and couples are saving for their first home and $4,500 doesn’t come close to meeting their needs.
A down payment is one of the biggest challenges that homebuyers face. They know bigger is better, but if you’ve struggled for years to save $4,500 then saving 10x that in a short period can seem like an impossibility.
The Ideal Down Payment and Why It’s Impossible
The ideal down payment is 20%. If you have a strong credit score and debt-to-income ratio, 20% is enough to secure a conventional loan with a low monthly mortgage payment. It will give you a sizeable chunk of equity right off the bat and make life easier for years to come. It will also minimize the interest that you pay over the term and could potentially save you tens of thousands of dollars.
However, first-time buyers struggle (understandably) to reach this target. The average purchase price in the United States is around $230,000, which means the ideal down payment is $46,000. Once you add moving costs, closing costs, and all the other costs of moving home, you could find yourself with a $55,000 bill.
It takes a lot of time and patience to save that kind of money and for the average first-time homebuyer, it simply isn’t within reach.
Research suggests that first-time buyers are making an average down payment of just 7%, which is a much more reasonable (but still sizeable) $16,000. For repeat buyers, it’s more manageable, as they cough-up close to 16% on average.
How to Calculate What You Need for a Down Payment
The 28/36 rule is often applied when calculating mortgage affordability. Your monthly payment (including property taxes and insurance) should not exceed 28% of your pre-tax income and your debt-to-income ratio (DTI) should not exceed 36% of your income. However, some lenders allow for a DTI of up to 43% and it all depends on the type of mortgage and the lender.
To calculate your down payment, use the 28/36 rule to estimate your anticipated mortgage and then calculate 3.5% of this total. This is the minimum you need for an FHA loan, which is one of the better options available to a first-time buyer struggling to make the down payment. For more preferable terms, calculate 10% or 20%.
For example, on a house valued at $200,000, 10% would be $20,000; 40% would be $40,000, and 3.5% would be $7,000.
20% should always be your goal. Only if you’re absolutely sure you can’t afford this should you move on. A 20% down payment will allow you to secure more favorable mortgage rates and give you more options further down the line. Many homeowners regret not increasing their down payment at the point of purchase, and you have a chance to avoid making the same mistake.
However, it’s not essential. There are minimum down payment assistance programs for conventional loans that allow you to pay as little as 3% and there are also Federal Housing Administration loans (3.5% to 10%) and VA/USDA loans (no down payment).
How Much Can You Afford?
A high down payment is better than a low one and the difference between 3.5% and 20% can be massive, including:
- No private mortgage insurance (could save an average of $100 a month).
- Better mortgage rates.
- Much lower monthly payment.
- Reduced interest paid over the term.
- Lenders are more likely to compete for your business.
- Better loan-to-value ratio to help with future equity schemes.
It’s important not to empty your savings accounts and spend every penny you have. It helps to have an emergency fund behind you when buying a home. If you ever run into issues with your monthly payment, you can simply tap into your savings and use that to cover the costs. Without it, you could be in serious hot water if you face financial difficulty.
How to Save for a Down Payment on a House
The sooner you start saving, the sooner you can buy your dream home. The average age of first-time buyers has been steadily decreasing since 2000 and is currently at around 35 years. This is generally how long it takes the average person to settle down, save, and make the decision to purchase a home. But there’s no shame in leaving it a little later and if that means you’ll have more money and a better credit score, it’ll benefit you to do so.
Here are a few ways you can save for a down payment and all the other costs associated with purchasing a house:
Special Savings Account
A special savings account is designed for the long-term and doesn’t allow the sort of easy access offered by a regular savings account. The minimum balance requirements are often very low (and occasionally non-existent) and they offer a compounded rate of return that is credited to your account every month.
The average savings rate in the US is pitiful at just 0.09%, but this accounts for a broad range of accounts and balances and if you actually spend time comparing and calculating, you can find something that offers a favorable rate of up to 2%.
Try to add money to the account consistently, preferably every month. If you save just $100 a month for 5 years at 2%, you will have saved $6,425 in total. A monthly savings account also allows you to save any windfalls you receive or increase your monthly payment. If you were to increase this investment to $200 and begin with a balance of $1,000, you’d have close to $14,000 after 5 years.
Long-term investments like stocks can help you save while generating a steady income from dividends. There are many risks involved with investing in this manner, but if you focus on blue-chip companies and put all dividends into a savings account, you could save a lot of money over 5 years or so.
Historically, the average rate of return on the stock market is 10% per annum (inflation rate not considered). This is over the course of a century and the annual rate of return is much smaller, but it’s still more secure than many people realize when you focus on big companies.
If we told you that you could save at least $10,000 this year without really trying, you’d think we were insane. But it’s true, at least for the average household.
The average US family spends $4,500 on a big holiday and takes at least 1 of these per year. In addition, a third of families take at least 2 smaller vacations, spending between $500 and $1,000 at a time. They spend in excess of $3,000 eating out every year, but at the same time, they waste 40% of the groceries they buy, accounting for around $1,500 in food waste.
$100 to $200 is spent on lottery tickets; $200 to $300 on unused subscriptions; $800 to $1,000 at coffee shops; $1,500 in workplace cafeterias. And that’s before we factor in the thousands that smokers, impulsive shoppers, and heavy drinkers waste.
Go a couple of years without a vacation. Take picnics instead of eating out. Monitor food waste to cut down. Stop smoking, drinking, and gambling. Do all these things and within a couple of years that 20% down payment won’t seem like an impossibility anymore.
Eliminate High-Interest Rate Debt
It’s difficult to find a balance between repaying debt and saving for a down payment. However, if you’re saving for a purchase to be made in 5 or 10 years, it’s always best to clear those credit cards first.
Every time you make the minimum payment on a credit card debt, you’re paying about 85% interest. The balance reduces slightly, interest builds again, and the next month the process is repeated. It could take years to repay the debt in full if this is your strategy and by that time you may have paid 50% to 100% in interest.
By focusing on getting the debt out of the way, you can increase your savings potential and ensure you have more money to put towards your down payment. It seems counterproductive, but in this case, you really do need to spend money to make money.
As an example, let’s assume that you have a $10,000 credit card debt with an APR of 25% and a monthly payment of $300. Your debt would be repaid in 58 months and cost you over $7,200 in interest. If, however, you increase your monthly payment to $600, focusing your extra cash on this debt and not your savings, that debt would clear in 21 months and cost less than $2,500.
You’ve now made room for $4,700, which you can put to good use as you build your savings over the next few years. What’s more, less debt means your credit score and DTI will be stronger, which could improve your mortgage rate and save you even more money.
This works best with credit card debt, but you can also run the sums with a personal loan, student loan or car loan. Generally speaking, these debts will be much higher and charge less interest, which means you may be better off focusing your money on the savings account. Alternatively, you can try a debt consolidation loan or a debt management loan. Read our page on how to pay off debt to learn more about these strategies.
Build an Emergency Fund
You can never underestimate the value of an emergency fund. It’s essential at any time and for any family, but it’s even more important when saving for a mortgage. An emergency fund will protect you against worst-case scenarios that could otherwise threaten your collateral and damage your financial prospects.
Your emergency fund doesn’t need to be huge. If you have a few grand left after covering the closing costs, down payment, and other fees, that should be enough. You can then simply continue saving money as you were before and move all this into your emergency fund.
How Long Does It Take to Save For a Down Payment?
All homebuyers are different. The time it takes you to save for a down payment will depend on your budget, debt, income, and cash flow. However, the average time needed to save for a 20% down payment is 14 years. If you’re in your mid to late twenties earning an average wage, you may need to wait until your early to mid-40s.
Summary: Know Your Finances
The more you understand about yourself and your affordability, and the fewer assumptions you make, the easier the down-payment savings process will be.
It pays to stay informed and the work you do now could save you a lot of time, stress, and money in the future. So, do your research, use an affordability calculator, a mortgage calculator; set financial goals, look into loan programs. Make sure you’re only ready to buy when you’re 100% certain about the road that lays ahead and confident you have the means to traverse it.