Even in the wake of the Great Recession, well over half of Americans — about 64% — own their homes according to the U.S. Census Bureau. It seems that home ownership remains a core tenet of the American dream and many have figured out how to save for a house. There are many advantages to owning your own home — it offers certain tax breaks, can provide financial stability in retirement, and can anchor you to your community.
But to realize the advantages of home ownership, there’s a pesky obstacle: the down payment. How exactly are you supposed to save for a house?
Although it might seem daunting to come up with tens of thousands of dollars for a down payment on a home, there are a few simple steps you can follow to make sure you’re in a position to join the ranks of America’s homeowners. It’ll take discipline and patience, but in the end, you could easily find yourself walking through the front door of an entire home that belongs to you. Here’s how to save for a house in six steps.
Step 1: Get Your Financial House in Order
The first step on your road to home ownership is to get your financial house in order. This means ensuring that you’re in a good place to actually purchase a house, and that said purchase won’t put you in a precarious place financially. After all, you don’t want the first maintenance issue in your new home to throw you into a debt spiral.
To make sure you’re ready to even start saving for a home, you should first make sure you have your emergency savings fully funded. In other words, you should have — at a minimum — three to six months’ worth of expenses squirreled away somewhere in case of, you guessed it, an emergency.
For instance, if your current monthly expenses tally up to $3,000 — this includes rent, groceries, insurance, car payments, medication, and any other expense that is essential to your well-being — that means you should have anywhere between $9,000 and $18,000 saved.
Pay Off High Interest Debt
Before you take on a mortgage, you should also pay off any high interest debt you have, or anything with an interest rate above 5.50%. This would include credit card payments, or high interest student loans that are still outstanding.
Not only will this lower your monthly expenses — thereby allowing you to more easily pay your mortgage — it will also save you money in the long run. After all, even if you only owe $1,000 in credit card debt with a 16% interest rate, it would take you almost five years to pay off if you were to pay the minimum payment of $25 each month. In the end, you would end up spending almost $500 in interest. Paying down that debt is an excellent idea, not just to help you save for a home, but to improve your overall financial health.
Improve Your Credit Score
Finally, before you apply for a mortgage loan, you should make sure to improve your credit score as much as possible. Your credit score is a number lenders use to gauge your ability to handle borrowed money. These numbers range from 300 at the low end of the spectrum, to 850 being the best credit score possible.
Your credit score is important when buying a home because it will determine the interest rate on your loan. For example, let’s say your current credit score is 630. With that score, most lenders would loan you the money at a 5.396% interest rate. Let’s say you take out a mortgage loan for $200K with a 30-year fixed rate. You would end up paying around $204K in interest — more than double the amount of the original loan. But if you were to take out that same amount with a higher credit score of 730, that interest rate drops to 4.029% for a significant savings of about $60K in interest payments.
Improving your credit score will take several months, so plan ahead before you start looking at potential homes. If you have minimal credit history or have had a few late payments, it’s important to build up your credit score to strengthen your mortgage application as much as possible.
Now that you’ve got your figurative financial house squared away, you can start thinking about purchasing a physical structure. But now you need to determine how much home you can actually afford.
To do this, start by calculating a monthly payment you can comfortably handle given your current income. Some personal finance experts recommend spending no more than 25% of your monthly take-home pay on your mortgage payment. Others say that 32% is a good percent of your income to shoot for all housing costs including mortgage payment, homeowner’s insurance, private mortgage insurance (if you need it), HOA fees (if applicable), and property taxes.
To ensure you don’t stretch yourself too thin and end up “house poor,” we recommend shooting for a home that will cost you a lower percentage of your take-home pay — that is how much you earn after taxes. Using the 25% example, let’s say Arthur brings home $4,000 each month after taxes. When we multiply his income by 25%, we find that he can afford $1,000 in monthly mortgage payments.
Knowing Arthur can afford $1,000 each month in mortgage payments, we can work backward to determine how much house he can afford. Assuming he can save up 20% of the cost of his potential new home — which will allow him to avoid paying for private mortgage insurance — using this calculator we find he can afford a home with a purchase price of up to $200K.
Step 3: Determine Your Down Payment Amount
Now that you’ve determined the upper limit of your budget for a new house, it’s time to calculate how much money you’ll need to put down. While most financial experts recommend saving up at least 20% of the purchase price of a new home — in Arthur’s case that would be $40K — there are several different types of mortgage loans that might cause your down payment amount to vary.
Traditional Mortgage Loan
Traditional mortgage loans, or those secured through a bank or credit union, usually have repayment terms set at 15 to 30 years and might have fixed or variable interest rates. While the exact terms may differ, a 20% down payment is recommended no matter which terms you choose.
Federal Housing Administration (FHA) Loan
This type of home loan is intended to help Americans afford homes who otherwise might be priced out of the housing market. Those who might benefit from an FHA loan are first-time home-buyers, as well as those with low incomes or little savings. In general, these loans have less stringent financial requirements — which can be very helpful if your credit score isn’t perfect. FHA loans also require lower down payments which can be as little as 3.5%. The only caveat is that FHA loans require you to pay mortgage insurance upfront, which can’t be canceled unless you make at least a 10% down payment.
GSE loans, or “government-sponsored enterprise” loans are those offered by Fannie Mae and Freddie Mac. These loan providers are currently offering home loans with a low 3% down payment, however they have much stricter qualification requirements than traditional or FHA loans.
VA loans are government-backed loans that often don’t require a down payment or mortgage insurance at all. However, they do require a funding fee that can cost you anywhere from 1.25% to 2.4% of the total loan amount. In the case of a $200K home loan, that would be $2,500 to $4,800. Additionally, as you might guess, these loans are only available to members of the military and their families.
The United States Department of Agriculture (USDA) also provides loans to those who are interested in purchasing homes in rural areas, and who meet certain income requirements. This type of loan also doesn’t require borrowers to provide a down payment or pay mortgage insurance, but they do have to pay an upfront fee of 1.00%. Again, in the case of a $200K home, that would be $2,000.
As you can see, the amount you would need to save up for your new home could vary from anywhere between 1.00% of the home’s purchase price, to 20.00%. However, no matter which type of mortgage loan you end up taking out, one thing is for certain: You’ll have to have at least some savings.
Depending on how much house you can afford and what type of loan you decide to take out, you know how much money you need to save. Now it’s time to start working toward your down payment savings goal.
Returning to Arthur’s example, we know that he takes home $4,000 monthly after taxes, and is shooting to buy a home that costs — at a maximum — $200K. Of course, the timeline he has in mind to actually purchase a new home will impact the amount he needs to save each month. In his case, let’s assume he wants to buy this house two years from now. We know he should have at least $40K for that down payment. Let’s see how Arthur can make progress toward his goal.
While budgeting is probably not anyone’s favorite activity, the process of evaluating how your money comes into and goes out of your accounts every month can often be eye-opening. You might think you can’t save any more than you already are — if you are, in fact, saving — but with a budget you might be surprised.
Using the 50/30/20 rule can often help you determine how much you can feasibly put away each month, and where you might be able to cut back. With this rule, you divide your monthly income into three different buckets:
- 50% Needs: This includes all the things you can’t live without. For instance, food, shelter, medication, etc.
- 30% Wants: These are the things you could potentially live without, although life would be less fun. This 30% of your income includes purchases like cable television, shopping, dining out, and other hobbies.
- 20% Savings: This is the bucket that will help you make it to your home savings goal. Once you’ve completed step one — e.g. saved up for an emergency fund and paid down high interest debt — you can start putting that 20% toward your house savings.
Again using Arthur’s $4,000 take-home pay as an example, and assuming he already has his emergency fund set aside, that means he could save $800 each month toward his home purchase in two years time. However, after 24 months, he would only have about $20K, which is short of his $40K goal. Dividing $40K by 24 months, we find that in order to reach his savings goal in two years’ time, he will have to up his savings rate to about $1,700 each month.
That might seem discouraging, but there are ways to speed up his savings rate and reach his savings goal faster. For instance, he could lower the amount he currently spends on essential items, perhaps reducing his rent payments by getting a roommate or moving into a more affordable apartment.
Additionally, he could reduce the amount he spends on wants each month by canceling any gym memberships or subscriptions he doesn’t use, or making coffee at home instead of buying a latte every morning before work. There are plenty of creative ways to save money fast if saving for a home is a high priority.
As a last resort — although financial experts will generally not recommend going this route as saving for retirement is crucial to a secure financial future — Arthur can temporarily lower his contributions to his 401(k) or IRA retirement accounts in order to put that money toward his new home’s down payment. However, if he decides to do this, he should make sure he’s still contributing at least enough to his 401(k) to capture any employer match.
If you’re committed to owning your home and you’ve cut your spending to the bone already, or know that you’re not a spendthrift by nature, you can try to earn more — and then save the extra income. For example, you could ask for a raise at your current job, or look for a new and higher paying position. After all, studies have shown that people who switch jobs see their wages grow more substantially year over year than those who stay in the same position.
To increase your earnings, you can also start a side hustle outside of your regular working hours. Many people drive for Uber or Lyft to supplement their income. You could also start a dog walking service, do some freelance writing on the side, or even start selling products you’ve made in online marketplaces like Etsy.
Finally, you could also pull money from your IRA. If you’re a first-time home-buyer, you can withdraw up to $10,000 from your IRA penalty-free, although you would have to pay the income tax due on that withdrawal unless it was from a Roth IRA. While we don’t recommend this, the option needs to be mentioned.
Maximize Your Savings
Now that you’ve come up with a savings plan, where should you stash all that cash? Rather than letting it sit in your checking account, there are a few options available to you that will help you maximize your savings.
For example, you can place your future down payment in a high-interest savings account that will allow your money to earn a bit of money on itself. That’s right, many of these accounts offer interest rates of between 2.00% up to 2.50%. In other words, if Arthur were to contribute $1,700 to his savings account for two years with a 2.25% interest rate, he would actually earn another $1,700 in interest.
High-interest savings accounts are an excellent option for home savings if your timeline is less than five years as they’re highly liquid and FDIC insured, meaning you can be sure your money will be there when you need it.
However, if you have five or more years of saving ahead of you, a Certificate of Deposit (CD), might also be a good option. These accounts often offer slightly higher interest rates — from 2.50% to 3.10% as of May 2019 — but require you to leave your money with the bank for anywhere between six months to five years to realize any gains. If you decide to withdraw your money sooner, you could potentially pay a penalty that would actually cost you more money than you would make in interest.
Step 5: Save for Additional Costs
This step in how to save for a house is often one that home buyers forget in their excitement at the prospect of home ownership. However, you should be aware that there are other costs besides the down payment involved in the purchase of a home. This list includes:
- Closing costs
- Inspection fees
- Utility adjustments
- Real estate taxes
- Cash reserves
These fees and expenses can add up quickly, substantially increasing the amount of cash you’ll need to have on hand when you decide to move forward with a home purchase. In Arthur’s case, it could potentially add another $10K to the amount he needs to have saved.
To determine how much you would need based on your own situation, take a look at this How Much Cash Do You Need to Buy a Home Calculator. Click “File” then “Make a copy” to input your own numbers.
Once you’ve met your savings goal for your down payment, as well as put aside a bit extra for any additional costs, you’re ready to seek out a mortgage lender and a real estate agent and start the fun part of the home buying process: house hunting.
While purchasing a home is not for the faint-hearted, if you follow these steps for how to save for a house you can go into the process with confidence and peace of mind. That way, when you finally walk through the front door of your very own home, you can enjoy your new home with satisfaction and pride.
(Additional detailed resources for how to save for a house are available from the U.S. government’s Consumer Finance Planning Board.)