First Time Home Buyer Series: How Much Savings Do You Need to Buy a House? Part 2/2

How Long Will It Take to Save Up for a Downpayment?
How much (what %) should I be Putting Down?

In Part 1 of this Post, we built a foundation to understand our level of risk tolerance, what an after-tax savings rate is, the impact it has on your saving velocity, and how long it will take you to have a basic level of financial security. If you haven’t already read Part 1, and you don’t already know how many months of living expenses you have saved and how much you need, please take some time and review Part 1 first.

In this post, we will dive into:
– How Much you will Need to Save for a Downpayment
– Low & High Downpayment Scenarios
– How Long it will likely Take You

Let’s dive right in.

How Much To Save for a Downpayment

If you pay less than 20% down, with a few notable exceptions such as a VA loan (no down program for veterans and active service duty members) or FHA loans (Federal Housing Association Loan, downpayment can be as low as 3.5%), you will usually have to get Private Mortgage Insurance (PMI).

PMI is insurance for the lender in case you default. It helps disperse risk, so lenders are more willing to issue loans for less of a down payment.

So really, in my mind there are two main approaches to a downpayment:
1) a “high” downpayment at 20% to avoid PMI
2) The bare minimum (no down, 3-5% down etc)

Which Level of Downpayment is Better?

It depends on your situation and your goals. As you may have guessed from Part 1, I tend to lean on the side of being financially conservative. So in my mind, it comes down to what you can afford? What does the monthly cost of ownership work out to be for you? What percentage of your income does home ownership take up? What is your debt-to-income ratio?

To more deeply understand what you can afford, take a look at this post:
First Time Home Buyer Series: How Expensive of a House Can I Afford?

Check In Question
Do you have a 6+ month Emergency Fund in place?
If not, read Part 1 of this post and figure out how much you need.

Moving forward on the basis that you understand what you can afford, let’s take a look at the financial impact of a 20% downpayment vs a 5% downpayment.

Hypothetical Scenario

• Home Cost = $325,000
• “Good” Credit Score @ 720
• 30-Year Mortgage Rate = 4.125%
• Monthly Income After Taxes = $6,000
• Monthly Net Savings = $1,000/month

Paying 5% Down

• Home Loan Amount = $308,750
• Major Up-Front Out-of-Pocket Expenses = $22,750
  • Downpayment = $16,250
  • Est. Closing Costs @ 2% = $6,500 (range from 1-3%)
• Monthly Expenses = $2,078++
  • Principal & Interest Expense = $1,496
  • Taxes = $219 (rough est., check for your area)
  • Homeowners Insurance = $233 (rough est., check for your area)
  • Private Mortgage Insurance (PMI) = $129
  • Factor in Maintenance as well

Time Required to Save Up 5% Downpayment on a $325,000 saving $1,000/month = ~23 Months, or 1 Years & 11 Months
($22,750 / $1,000)

Paying 20% Down

• Home Loan Amount = $260,000
• Major Up-Front Out-of-Pocket Expenses = $71,500
  • Downpayment = $65,000
  • Est. Closing Costs @ 2% = $6,500 (range from 1-3%)
• Monthly Expenses = $1,713++
  • Principal & Interest Expense = $1,260
  • Taxes = $219 (rough est., check for your area)
  • Homeowners Insurance = $233 (rough est., check for your area)
  • Factor in Maintenance as well

Time Required to Save Up 20% Downpayment on a $325,000 saving $1,000/month = ~72 Months, or 12 Years
($71,500 / $1,000)

If we compare the two, at just under 2 years for a 5% downpayment is actually quite fast. 12 years for the 20% downpayment though is a looooong time. If you don’t already have a fully funded Emergency Fund, and have to add that on top as well, I wouldn’t blame you for feeling overwhelmed.

Where do you come in?

Group A: I have enough to make a 20% downpayment, pay closing costs & have a fully funded Emergency Fund that I’m comfortable with

Group B: Some version of not there yet

For everyone in Group A, good for you! My guess is that you aren’t reading this blog post though, so to all my friends in Group B. You got this!

Which downpayment approach is better?
I dive into that topic in this post here:
First Time Home Buyer Series: How Much Should I Put Down on Buying a Home? Understanding the Pros & Cons of the Downpayment.

A quick two-cents though, if you’re conservative, buy a cheaper home that requires less down, while keeping the highest after-tax savings rate that you can manage.

What About…looking at different life situations

Q: What if I live in an area where homes are unreasonably expensive?
My Take: That is a very real issue for many parts of the U.S., with housing transitioning to an asset class for speculation and investment vs. basic necessity only. There isn’t an easy answer, but there are a simple ones.

If you’re committed to being in the area:
1) Position yourself to earn & save more, and know it will take you longer to become a homeowner
2) Settle for a less expensive home, likely further out
3) Explore alternative living arrangements like Shared Living, manufactured homes, renting out a room on Airbnb etc
4) Pay less down, but with eyes wide open regarding the risks

If you’re not 110% committed to being in the area:
1) Seriously consider relocating, as many have done already, from areas like San Francisco
2) Leaving is fine, but make sure that you’re heading to an area where you will be better off. Take a look at the article I did on affordability to help get you started in figuring out a better alternative.

Q: What if I’m already being frugal and trying to save as much as I can, but the cost of living is such that I’m not making much progress?
My Take: Essentially the same answer as above. I have friends who were living in New York City and were working in jobs that didn’t pay top dollar. Fast forward several years and they relocated to North Dakota. Not saying you have to move, but if you’re not in a high paying profession, stay away from cities with a high cost of living. Your retirement will thank you.

Q: What about if I find a good deal, but can only afford a 5% downpayment?
My Take: Are you sure it is a good deal? What is it based on? If so, and you qualify for financing, have an Emergency Fund saved up, haven’t forgotten about closing costs and moving costs etc, and you’re really sure you have a great deal, then I would pounce on it!

When we were looking for homes, after looking at around 15 homes over several weeks we found a good deal and contacted the buyer the same day and signed a purchase agreement the next. Sometimes timing is really crucial. In our case, it was as FSBO (for sale by owner) and it hadn’t “gone live” online yet (took 2 days to be reviewed on Zillow at that point). We bought it before it went online at less than market rate.

As they say in real estate, “you make your money when you buy, not when you sell.”

3 Approaches to Help You Get There

1. Save More Tomorrow
2. Buy a Less Expensive Home
3. Invest

1) Save More Tomorrow

From time-to-time, you may get a salary increase at work or a bonus (or earn more through a side-hustle etc). The idea is to keep your current expenses the same, but to commit to saving (and automate) a large portion of the after-tax increase in income. This is a great opportunity to increase your saving power without negatively impacting your current lifestyle.

This approach, known as “Save More Tomorrow,” was pioneered by Nobel laureate and behavioral science and economics professor Richard Thaler, and has helped millions of Americans save more for retirement. You can use the same principals to help you get ahead.

2) Buy a Less Expensive Home

While not not as appealing as having the bigger home in a better neighborhood, buying a less expensive can be a smart approach for a number of reasons.

1) Quicker to save up the downpayment

2) Even if you already have the money, it ties up less of your net worth in your home (have most of your net worth in your home is a classic middle-class financial strategy, not what the wealthy do)

3) Easier to rent out should you need to (lower interest payment = higher chance the rent will cover your mortgage and expenses)

3) Invest

You may have modest savings today, but if you take a mid-to-longer term outlook, investing your savings (excluding your Emergency Fund) for a home downpayment can be a smart strategy. However, it is also a strategy that opens you to market risk. If you’re considering this option, ask yourself what the cost and impact of delaying home purchase would be.

If you had $10,000 and needed $20,000 for a home downpayment, at an 8% annual return it would take you around 9 years to get there. A lot can happen in 9 years though, and you may be buying at a high point and need the funds at a low point. That’s why I don’t really recommend this option unless you’re well ahead of the game (think early 20’s or teens). This is not a strategy to rapidly increase your wealth, so hoping to get significant returns here in the short-term is a risky proposition.

Which approach/es resonated with you?

Probably none of them right? I know, me too. Who doesn’t want the nicer house in the nicer neighborhood, and want it yesterday? That being said, for everyone in Group B, we have to figure out how to be smart for our specific situation.

Summary

• Your savings rate is critical to your financial stability
  • With an “average” after-tax savings rate of 7.9%, saving up for a home isn’t realistic. Something has to change to make owning a home a reality.
• Saving up 20% for a downpayment takes a long time if you have a low savings rate and your income in relation to the cost of the house is low as well…it was around 12 years in our example!
• If you’re serious about being a homeowner and it isn’t realistic in the area you live now, starting to plan your next move may be smart

Final Thoughts

To sum up, we’ve seen that it takes much longer to have a 20% downpayment than it does to just put down the minimum. On the one-side, you have to pay less down up-front, but on the other your monthly expense is also significantly higher. As they say, “there is no free lunch.”

Hopefully by reading this article, as well as others in the First Time Home Buyer Series, you will be better equipped to understand your own situation and what makes sense for you.

Please share in the comments if you have questions/thoughts and I will do my best to get back to you as soon as I can.