How to save money for a down payment to buy a house
Soaring rents is preventing people from saving for a down payment, but saving is a critical first step to become a home owner.
The biggest barrier to sales today is the lack of a down payment. In the post How restricted for-sale housing inventory saps demand, I demonstrated how stagnant wages and high rents hinders people from saving enough to obtain a down payment on a house. It’s one of a number of reasons Millennials aren’t buying homes at a stage in their lifecycle when previous generations did.
During the housing bubble, people had access to 100% financing, so few were saving for a down payment. After the housing bubble, the Great Recession caused many people to dip into savings just to make ends meet. Further, since the federal reserve lowered interest rates to zero, beyond the emotional need for reserves for stress reduction, people had little or no incentive to save.
The end result of these circumstances is that very few potential homebuyers have the necessary down payment, even the paltry 3.5% required by the FHA. And since renters put a large percentage of their income toward rent, even if they wanted to endure 0.2% savings interest rates, they don’t have the disposable income necessary to save for a down payment. There is no magic bullet or simple solution to this problem.
Perhaps it’s “old school” and unfashionable in our modern era of unlimited entitlement, but the only way to save for a down payment is for potential homebuyers to sacrifice current consumption and adjust their finances to live within the constraints of their income.
People can adjust to whatever income and expenses they have if given a little time. Transitioning from renting to home ownership shouldn’t be a difficult adjustment if you follow a few simple guidelines for structuring your finances while you’re still renting. To make the adjustment, you need to carefully budget for saving for a down payment and making the house payment once you purchase. Fortunately, this is not as difficult as some imagine.
The first task is to figure out how much you will have to spend each month when you own your home. Lenders don’t pity borrowers, but they are very concerned with an acronym called PITI, a formula they use to calculate the maximum monthly payment you can afford. PITI is short for principal, interest, taxes and insurance, but it also includes other known costs such as HOA dues and mortgage insurance. When a lender calculates the maximum loan they will extend a borrower to buy a particular property, they start with the borrowers income and apply the maximum debt-to-income ratio, currently 31%. They take this number and divide it by 12 to come up with a maximum PITI.
For example, let’s say a borrower making $100,000 per year wants to buy a home. The lender will allow them to put $31,000 per year ($100,000 x 0.31) or $2,583 per month to cover PITI. This number is very important because it tells you how much you can expect to write checks for each month if you max out your loan (most do) to buy a home.
Maximum loan balance
When lenders calculate your maximum allowable loan balance, they back out taxes (including Mello Roos), insurance, and HOA dues to calculate the remaining amount left over to cover the payment, which includes principal and interest. Generally, about 25% of PITI is consumed by taxes, insurance and other costs. Let’s assume $583 is consumed for these backed-out items. The remaining $2,000 is available to make a payment. From that, lenders use another formula that takes into account the interest rate to calculate the maximum loan balance.
If we stay with our example from above, a borrower making $100,000 per year making a $2,000 monthly payment can borrow $440,000 using 20% down conventional financing or $381,175 using FHA financing. The difference is caused by the lower payment due to the high cost of FHA mortgage insurance.
Rent and Savings
As a renter hoping to buy, you must adjust your lifestyle to fit within your PITI amount. Your current rent should be far enough below this figure to allow you to save money for your down payment. But how much below? What is a good guideline for determining the maximum rent you should be paying each month? This is an important question because if you base your selection of a rental based on the PITI of your ultimate cost of ownership, you will also become accustomed to living in the quality of home you will ultimately afford to purchase. Fortunately, there is a formula to figure this out.
I’ve run the cost of ownership calculations on thousands of properties. The monthly cost of ownership is generally 25% to 30% below PITI. This monthly cost of ownership relates to rental parity, the foundation of housing market values.
If you use that guideline, a renter making $100,000 a year should be paying about $1,900 in rent and saving about $700 per month toward a down payment. That translates to a 23% rent-to-income ratio. Anyone with the discipline to live this way will be able to save for a down payment and comfortably transition to home ownership. Anyone who doesn’t have the discipline to live this way may not be cut out for home ownership.
From the above example, a $440,000 conventional loan balance leaves a $110,000 down payment to purchase a $550,000 house. Notice that 3.6% interest rates allow borrowers to purchase at price-to-income ratios of 5.5. That’s very high by historic standards.
It only takes 20 months to save for a down payment
At $700 per month, it will take 158 months to save the $142,052 for a down payment. Thirteen years is a very long time. That’s why so many people opt for FHA financing with 3.5% down. At $700 per month, it only takes 20 months, or just over a year and a half, to save the $13,825 required to cover the FHA down payment on a $395,000 property.
Did you notice the catch to using FHA financing? People who don’t have a 20% down payment have to settle for much less house on the same income. This is why the tradition of buying a starter home, waiting until it accrues 20% equity, then selling for a move-up is such a big part of our housing market.
The bottom line
To prepare for home ownership, rent a property using 23% or less of your gross income. Save 8% of your gross income in a special down payment account you don’t raid for other lifestyle expenses or purchases. In less than two years, you will have the down payment to purchase a property comparable to your rental using FHA financing. With the discipline you gained from living within your means and saving for a down payment, you will succeed as a home owner and build equity through paying down a mortgage. You might even be rewarded by the appreciation fairies and complete a move-up once you have about 30% equity in your home and you can sell, cover the closing costs and still have 20% for a down payment on a nicer property.