Even if you don’t plan to buy a house for several years, you’ve probably started thinking about how to save for a down payment. Unlike saving for retirement, where the funds you stash away likely won’t be accessed for many more years, a down payment is a large sum of money that you’ll need to access soon.
This means slowly setting aside small amounts and investing them in the stock market just won’t work.
In these seven steps, we’ll cover how to start saving for the biggest purchase you’ll likely every make, and how to do it in the smartest way possible.
Step 1: Find the best way to save for your down payment
As a rule, since the money that you are saving for the down payment on a house has a definite purpose, and needs to be reached within a specific timeframe, you should not save money in risk-type investment vehicles (stocks, realestate investment trusts, ests.) Instead, you should save your money in super-safe vehicles like a boring old savings account or a certificate of deposit.
Sure, you may be able to earn more money by investing your down payment account in higher risk vehicles, but there is also the very real risk that you will lose money in the process.
Remember, if you’re saving for a house, the worst-case scenario would not be missing out on returns, it would be losing some of the money you needed to buy your home.
Step 2: Figure out how much you’ll need to save
Before you begin saving a down payment for a house, you first have to know how much you’ll need to save. Plan to sit down with a mortgage lender who will let you know how much of a mortgage you can qualify for.
Generally speaking, your housing expense should not exceed 28 percent of your stable monthly income. So if your income is $5,000, you can safely allocate $1,400 of that ($5,000 x .28) to your future house payment.
The $1,400 will include mortgage principal and interest, real estate taxes, private mortgage insurance (PMI), homeowners insurance, and homeowners association (HOA) dues, if any.
With mortgage rates at about 4.5 percent, this will translate into a mortgage loan amount of about $177,500.
To arrive at the amount that you can afford to pay for a house, you’ll have to add the down payment on top of that. In today’s tight lending market, you should generally expect to make a 20 percent down payment on a house. No, that’s not a requirement–it’s just the minimum down payment to get the best-priced deals.
You can certainly put down less, but you will likely be paying a higher rate and, if you have any kind of credit issues, you may not be able to get a mortgage at all.
So taking our example of a mortgage for $177,500, and making a provision for a 20 percent down payment, we can calculate the actual dollar amount this way:
$177,500 divided by .80 = $221,875, minus the $177,500 mortgage loan = $44,375, or rounded up, $45,000
Rounding the numbers up, you’ll be purchasing a house for $222,000, with a $177,500 mortgage, and a down payment of about $45,000.
Don’t get hung up on those calculations– a mortgage lender can perform the same calculations for you based on your own financial circumstances. We’ve done this for illustration purposes only, and so that we can carry that $45,000 number forward for more calculations.
Step 3: Determine your timeframe
The next step is to determine your timeframe. If you plan on purchasing a home in five years, you’ll have to be prepared to save $9,000 per year ($45,000 divided by five years).
Naturally, the shorter your timeframe is, the higher your annual savings goal will be.
Step 4: Make room in your budget
Since we’re talking about saving thousands of dollars per year, you have to clear some room in your budget to make sure that your savings goal is doable. That means you may have to earn additional income, cut back on expenses, or both.
But, making room in your budget can help you save the kind of money you’ll need for your down payment, and it will also prepare you for managing the type of tighter budget that homeownership requires. Embrace it for all it’s worth!
Step 5: Bank those windfalls
You can make the process of saving money for a down payment on a house easier—or even shorten the process—by banking periodic windfalls. These can include income-tax refunds, gifts received, bonuses or large commission checks, or even the sale of personal assets.
By depositing these funds into your down payment savings account, you fast-forward the process of saving money to buy your future home. Regularly depositing a few thousand dollars per year in windfalls can chop a couple of years off of your savings timeframe.
Step 6: Build flexibility into your savings plan
Whatever the size of your down payment, it is important to build flexibility into your savings plan.
While you’re saving up money, there’ll be other demands on your finances. These can include major car repairs, replacement of a car, uncovered medical expenses, or even the temporary loss of a job. None of these will magically stop just because you have a goal of saving money for a down payment on a house. You’ll have to be ready when they happen.
Make sure that you have an emergency fund—before you even start saving for your down payment—and keep it well-stocked. And if you have predictable expenses, such as replacing your car, you’ll need to simultaneously prepare for that expense as well.
Step 7: Set up an automated savings plan
Unless you’re a saver by nature, and most of us aren’t really, you’ll need to automate the savings process. That will mean some sort of payroll savings plan. Just like your 401(k) plan, you should allocate a certain percentage or dollar amount of your regular pay to go directly into a savings account or money market account dedicated to accumulating the funds for your down payment.
Not only does this make the process automatic, but it also makes it invisible. Money moves from your paycheck to your dedicated savings account without you even seeing it happen. That will remove both the temptation and ability to spend the money on other purposes.
Summary
Buying a home can be a long process that requires a good chunk of your savings, but think of it all as preparation for homeownership. You’ll have all of those expenses after you buy your home too, but you’ll also have large expenses related to the home itself. So think of this as a dry run to prepare both your finances and your psyche for the extra expenses that homeownership brings.