First Time Home Buyer Series: How Much Savings Do You Need to Buy a House? Part 1/2

With the price of homes on the rise, the up-front cost to buy a home can be a shock to the unprepared. You may have already known that saving up to buy a home is a multi-year endeavor, but follow me as we take a deeper dive to see what you should expect to have saved up in order to buy a home AND still be reasonably financially secure (i.e. have enough savings to weather a job loss, unexpected healthcare expense etc).

In this post, we’ll take a look at how much you should have in savings and how long it will likely take you to get there BEFORE you’re in a position to prepare for buying a house.

In Part 2 of this post, building on the framework presented below, I’ll dive into how much you need for a downpayment, and how long it could realistically take you to get there.

You already have an Emergency Fund, but is it enough?

My guess is that you already have some money set aside for a rainy day.

The question is, how much do you really need? What about saving for retirement? For kids college? What type of account should it be in etc?

It can get quickly complicated and overwhelming.

So, let’s start with the basics and some simple math.

The first thing to understand is your after-tax (net) savings rate.

So, if you earned $5,000/month after tax, and saved $1,000/month, you would have an after-tax savings rate of 20%.

The Simple Formula Is
Step 1: Income After-Tax – All Monthly Expenses = After-Tax Savings
Step 2: After-Tax Savings / Income After-Tax = After-Tax Savings Rate

I emphasize after-tax earnings and savings here, because more advanced discussions that involve tax efficiency are beyond the scope of this post. In short though, there’s not a lot that you can do at a basic level of avoid taxes as an employee, so measure yourself taking taxes out of the equation.

Retirement Accounts & Brokerage Accounts Don’t Count
The catch is, don’t include your 401(k), IRA, 529 College Savings Plan or other special purpose long-term contributions as part of your Emergency Fund savings. To illustrate, if you are saving $1,000/month after-tax, but $500 of that is going into a 401(k), then for the purpose of the Emergency Fund, you are saving $500/month. The same goes for your stock or other brokerage account.

Why? Because the purpose of these accounts is to set money aside for the long-term, and they are illiquid in nature. The IRS makes sure that you really, really don’t want to use these funds unless you absolutely have to as they come with steep penalties. The purpose behind setting them up is entirely different, so don’t mix long-term investments with short-term liquidity needs.

A second point, your Emergency Fund that should be held in a:
– safe (think FDIC insured), and
– highly liquid account (think checking, savings, money market).

Having a Hard Time Keeping Track of Your Net Savings Rate?

A simple way to calculate your net savings rate that I use is to pay for essentially everything by credit card, bank transfer or check (yes, believe it or not, it’s still a thing), so there’s a record of it in my bank account.

Then, all I have to do is look at my online bank statements and take my income less expenses divided by my net income. I also keep a spreadsheet to monitor my progress month-to-month and year-to-year.

To make life easy, I use a simple cash-basis approach, meaning that for credit card expenses, I’m only counting the statement I pay in that month in that month’s expenses. You could look at your statements and figure out exactly how much you spent in each month, but if your income is stable, I don’t think it’s worth the additional effort as your credit card bill likely crosses monthly periods.

So, what is a “good” savings rate?
Or put another way, what should my savings rate be?

Let’s take a look at a benchmark put together by the U.S. Bureau of Economic Analysis : the Personal Savings Rate (PSAVERT).

This is a long-term graph of U.S. Personal Savings Rate. You can see that the U.S. Personal Savings Rate has been as high as 17.3% back in the 1970’s, and has since declined to around 7.9% in November 2019. The all-time recorded low was 2.2% in July 2005.

So, to start with, how do you compare with the U.S. National Average shown above?

Now, let’s take a look internationally at how other economically developed countries save.

Interestingly, it seems to be all over the place. Many countries are lower than the U.S., and some are quite a bit higher. Take China for example at 36.14% in 2016! Switzerland also has a high relative savings rate at 18.79%. The U.K. is at at scary 0.37%, with Spain and Canada not far behind at 1.52% and 1.69% respectively.

Benchmarking can be interesting, but what about your specific situation?

How much should you have in savings?

Speaking from personal experience, when I needed to relocate to a new city and start networking and looking for jobs from scratch, it took me around 7 months to find a good job and get back on my feet. Some people will be faster, others slower depending on your specific situation.

I also graduated into the Great Recession just as things were really starting to fall apart (Lehman Brothers filed for bankruptcy a few weeks before I graduated, killing my job offer at a well-known stock brokerage).

This launched me on a random job trajectory few years, from consulting on overseas expansion initiatives for Japanese companies into South East Asia, to project management for an Iron Ore Mining startup operation, to teaching English, to setting up a joint venture for a Thai advertising agency in India and so on.

This lack of job security translated into a lack of financial security, and has given me reason to err on the side of caution. I believe that our financial situation needs to be robust enough to weather the storms that life throws at us, and also have the liquidity to invest when there’s a good opportunity.

As the old adage goes, “hope for the best, plan for the worst.”

What I hope you take from my story here, is that there’s no magic bullet or right answer for everyone: it’s about risk appetite.

Just like when you open a trading account, or work with a financial advisor and they have you fill out a survey regarding how you feel about risk, here too it can be informative to ask yourself some questions like the below to get started (certainly not an exhaustive list).

Diagnosing How Much Risk You are Willing to Take

• How much of my expenses are fixed vs. variable ($ amount & %)?
  • Fixed Expense Examples = Not Easy to Change in Short-Term
    • Housing
    • Utilities (amount will vary by usage, but rate is fixed)
      • Yes, you can use less…but will you really? People are creatures of habit, and my guess is that you will still keep the lights on, use Internet, pay for garbage removal etc
    • Basic Food Needs
    • Transportation (Gas, Insurance, Car Payment)
    • Debt Repayment (that can’t be deferred due to financial hardship)
  • Variable Expense Examples = Easier to Change in Short-Term
    • Eating Out
    • Alcohol, Snacks, Non-Necessity Food Items
    • Entertainment/Cable etc
• Based on the above, how much do I really need to get by per month? Add 20% for unexpected expenses.
• If I was without work, how long would it take me to find work again at the same pay level? What has been the recent experience of friends, colleagues, former colleagues etc in similar roles/industries
• On a scale of 1-10 (1 = lowest), how comfortable would I be building up credit card debt to pay for living expenses?
• Based on my current and expected realistic new income post-hypothetical setback, how long would it take me to repay:
  • 3 Months Living Expenses with 18%+ interest
  • 6 Months Living Expenses with 18%+ interest
  • Use a calculator like this one to take a few minutes and really figure it out, using the interest rate from the card/s you use and the amount you calculated above with the additional 20% margin of error
• On a scale of 1-10, how readily available are support systems for me to fall back on?
  • Could I ask friends, family to support me? Would they?
  • Could I move back in with parents?
• On a scale of 1-10, how comfortable would I be relying on others during hard times?

There isn’t an all-knowing table to tell you how many months is the right amount, but I would start-off with 6 months living expenses in savings as a bare minimum. Suze Orman recommends having 8 months living expenses saved up if you are planning on buying a home. Based on the above, if you want to be really covered and have a very low risk tolerance, you may want to have even more.

How long will it take to reach my Emergency Fund Target Amount? What is my Saving Velocity?

Ok, you’ve seen that life would likely get tough without an Emergency Fund in place. Let’s get into the real nuts and bolts and see just how long it will take for you to get to square-one, or if you’re already there.

Sample Emergency Fund Planning Assumptions

• Current savings are essentially zero for an emergency fund
• $5,000 in Monthly Income After Taxes
• $4,000 in Monthly Expenses Excluding Taxes
• $1,000 Average Monthly Savings Rate into Savings Bank Account
• 20% After Tax Savings Rate

Scenario 1 – 6 Months Living Expenses

• 6 Months Living Expenses = $4,000 x 6 = $24,000
• Time Required to Save $24,000 = $24,000/$1,000 = 24 Months = 2 Years

Scenario 2 – 8 Months Living Expenses

• 6 Months Living Expenses = $4,000 x 8 = $32,000
• Time Required to Save $32,000 = $32,000/$1,000 = 32 Months = 2 Years 8 Months

Scenario 3 – 12 Months Living Expenses

• 6 Months Living Expenses = $4,000 x 12 = $48,000
• Time Required to Save $48,000 = $48,000/$1,000 = 48 Months = 4 Years

You can see from the above, that even at a relatively “high” savings rate of 20%, saving enough for an Emergency Fund is no joke. Most people never get this far (just take a look at the U.S. Personal Savings Rate). This is really the first step on the road to financial stability.

To drive the point home though – as this is so important I can’t over emphasize it enough. At a 7.9% after-tax savings rate.

• Same $5,000 Monthly Income After Taxes
• $395 in Monthly Savings After Tax (what it works out to be at 7.9%)
• $ 4,605 in Monthly Expenses

Here is how long it would take to reach an initial level of financial security.

• 11.65 Months Working to Save 1 Months Livings Expenses – that’s essentially working 1 year to have 1 months living expenses!!!
• That works out to be around 3 years (for 3 months), and you guessed it, almost 6 years working to save up for 6 months living expenses

Scary right?

That’s why having a high savings rate is the most basic and most important step in creating financial stability.

There are so many shiny baubles out there, things that we would like to have, that really getting this is key to spend correctly for the amount of income you make.

“It’s Not What You Make, It’s What You Keep”

I’ve known people who made solid six-figure incomes, but who spent the vast majority of it, and we’ve all heard about bankrupt movie stars and rock stars who made mega-millions, so it’s not about “making enough,” it’s about keeping enough and saving to get ahead.

You’ve probably already guessed it, but with a 7.9% personal savings rate, home ownership is not realistically in the cards for 99% of people with that level of savings rate unless they get a low/no-down loan, help from relatives or a very big bonus.

Reality Check
If you aren’t, or can’t save 20% or more of your after-tax income, owning a home may not be a financially sound decision for you.

Challenge yourself to save more if you’re serious about owning a home.

Why the tough love?

Even at a 20% savings rate, it is still taking 2 years and 8 months to get an 8 Month Emergency Fund in place. That’s before the home downpayment, closing costs, home inspection and so on.

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

We can apply the same principals to this calculation, but I will go into more depth on the topic here.