Takeaways
- Saving for a down payment is often the largest barrier to buying a house.
- Creating a budget to save for your down payment is a smart money move.
- There are many mortgages that don’t require high down payments.
- Personal finance experts recommend a 20% down payment.
- Down payments affect mortgage affordability and long-term payments.
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Buying a home is a considerable financial decision. If you are in the market to buy a house, you have probably felt sticker shock at how expensive the home-buying process has become over the last decade. Real estate prices have reached historical highs, and rising interest rates have dramatically increased the costs of mortgages.
As a first-time home buyer or a buyer looking to purchase a larger home, one of the major hurdles is saving for a down payment large enough to ensure your mortgage is affordable over the long term. Making a larger down payment today can help your budget later, freeing up cash flow to help you reach other financial goals.
What is a Down Payment?
A down payment is an initial lump sum cash payment to a lender when purchasing a home, expressed as a percentage of your total home price. Your down payment is made to your mortgage provider at the close of your transaction to reduce the total mortgage you owe.
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Saving for a down payment is the highest barrier to entry into the housing market. For younger professionals, a down payment can take years of diligent savings or a major financial windfall. Because saving for a down payment can take a while, it is vital to break down the process of saving for a down payment into actionable steps.
9 Steps to Save for a Down Payment
Here are nine Smart Money steps to help you save for your down payment and purchase your perfect first home.
1. How Large Is Your Down Payment?
A traditional financial rule of thumb is to make a 20% down payment on a mortgage. By paying 20% down, you avoid paying Private Mortgage Insurance (PMI), which only increases your monthly housing costs.
Financial experts who recommend paying 20% down also highlight that if you can pay 20% for a down payment, you can probably afford your mortgage in the long term. This high down payment is not required to secure a home loan, and lenders can be flexible depending on your situation.
Check out the Smart Money down payment calculator below. This can quickly help you determine how much you need to save to afford your ideal house.
Calculator
Down Payment Calculator
Home lenders analyze several financial factors when determining how much home you can afford. For example, if you have an excellent credit score and are completely debt-free, that is a very different profile from someone with high levels of consumer debt or student loans. Home lenders want to ensure you can make your loan payments; they calibrate how much they will lend and what interest rate they will charge based on your financial profile.
Different types of home loans require different levels of down payment. Here is a listing of different types of home loans and their corresponding minimum down payment requirements:
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Conventional Loans
These are the most popular loans offered by home lenders and are not backed by a government agency. Conventional loans are perfect for homebuyers who can put at least 3% down, although financial experts recommend making down payments as high as 20% or more. These loans meet underlying guidelines set by Fannie Mae and Freddie Mac.
Jumbo Loans
If you are buying a house that costs more than the 2023 baseline conforming loan limit of $726,200, set annually by the Federal Housing Finance Agency, then you will need a jumbo loan. Because these loans exceed the amount of a conforming loan, lenders require higher down payments, typically at least 20% of the home value, although some lenders will go down from there.
FHA Loans
Backed by the Federal Housing Administration, FHA loans require smaller down payments that vary by credit score and history. Down payments for these loans can be as low as 3.5%.
VA Loans
If you are a current or former United States service member, you may be able to skip the down payment altogether. VA loans, which are backed by the U.S. Department of Veterans Affairs, sometimes don't require a down payment.
USDA Loan
Another loan that may not require a down payment is a USDA loan. These loans are backed by the U.S. Department of Agriculture and are typically reserved for homeowners in rural areas. Oftentimes, USDA loans have an income limit tethered to loan qualification.
2. Create A Plan
No matter what type of home loan is right for you, creating a plan to save your down payment will be a central part of your success. Take a collective inventory of all your assets and liabilities. This will give you a snapshot of your net worth.
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The next step is to determine how much of your assets you can contribute to saving for a down payment. For example, if you have $20,000 in investments that you can contribute, then understanding how those investments fit into your overall savings plan is helpful.
Reverse engineer how you are going to reach your down payment goal. If you want to put down $50,000 toward your down payment, then you need to make a budget that allows you to save the remaining $30,000 ($50,000 Down Payment-$20,000 in Investments = $30,000 Remaining Balance) to purchase a house.
3. Build A Budget
There is an old business saying that “You can’t manage what you don’t measure.” Saving to reach a financial goal is no different. With how much you want to save for your down payment, you can now focus on creating a budget that achieves this financial goal.
Start the budgeting process by listing your income and your expenses. If you have a positive number, you are in a great spot and can start focusing on the easiest place to begin cutting expenses. There are countless ways to reduce monthly costs.
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Increasing your income is another way to improve your budget. Sticking to a budgeting process that works for you is critical. There are many ways to budget, including passion budgeting, which aligns your spending habits with your interests.
4. Pay Off Debts
One of the fundamental metrics mortgage lenders focus on is your debt-to-income ratio. Lenders want a low debt-to-income ratio before issuing a mortgage. If you plan on securing a loan soon, you can begin planning to make yourself an attractive borrower.
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Reducing your debt level can help you increase how much the mortgage lender gives you to purchase your house. The lower your level of consumer debt and the higher your credit score, the better.
5. Use High-Yield Savings Accounts
You will be saving thousands of dollars for your down payment. Because of this, it makes sense to store this capital in an account that generates a low-risk return. That is where a high-yield savings account comes into play.
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High-yielding savings accounts are great places to save money to meet your short-term and long-term goals as well as an excellent place to keep your emergency fund and slush fund. If you are already doing the hard work of saving, let your money work for you and accrue interest. Choose an account that is easy to access, offers incentives to set up, gives you a high Annual Percentage Yield (APY), doesn’t charge for transferring funds, and is insured by the Federal Deposit Insurance Corporation (FDIC).
6. Increase Income
Increasing your income will help you become attractive to lenders because they want to ensure borrowers have sufficient monthly cash flow to pay their mortgage expenses. Concurrent with slashing your expenses, you can work on increasing your income.
With dedication and focus, you can improve your income quickly. You can start an online business, pick up a side hustle, or monetize assets you already own, like your car or house. In today’s economy, there are numerous ways to make more money. Asking for a raise or promotion can also be another excellent way to increase your cash inflow.
7. Automate Your Savings
Having to manually decide to save for your down payment each pay period can actually increase the chances that you don’t save enough. Financial experts recommend automating your decision to remove decision fatigue, or the idea that it takes mental effort each time you decide, from your savings process.
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Set up an automated workflow where deposits are automatically transferred from your checking account to your savings account. You should use financial psychology to increase your savings by giving your high-yield savings account a unique name. Research shows that naming your savings account increases your readiness to save along with your actual savings rate. This technique will allow you to save for your down payment faster.
8. Meet with A Financial Advisor
A financial advisor is a professional who can provide planning, investment, and insurance services. Buying a home is such a large financial decision that planning how to manage the transaction can be very helpful to your long-term financial success and save you money.
Like all investments, buying a house involves risk. Many people buy a house they can’t afford, that is too small for their long-term family goals, or has physical issues such as structural damage. Financial advisors can also help with contemplating what level of homeowner’s insurance and other insurance, such as life insurance, you might want.
9. Become a First Time Homebuyer
With your down payment in hand, you can start home shopping. This process can be different and feel overwhelming for first-time home buyers. One key metric to know is how much you want to spend on your house. Your budget will narrow your search and allow you to focus on finding the best home for you.
Being financially prepared when purchasing a home will set you up for success. Double-check your numbers and be comfortable with your purchase. With such a monumental purchase, take a step back and enjoy the process.
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Smart Summary
Buying a home is one of the biggest transactions of your life. The right time to buy a home is completely dictated by your financial health, not timing the market (although there can be some good fortune with this). With the right level of financial footing, you can make the process incredibly enjoyable and take the time to choose the perfect home. There are many expenses associated with homeownership, so do your due diligence to understand the total cost of homeownership. Be smart with your money moves, control your emotions, and save up for the down payment required to finally buy that perfect house.
Frequently Asked Questions
This is probably one of the most common questions asked during the home-buying process. How much house you can afford depends on your level of comfort with the mortgage. Each person is different. If you pay a hefty down payment and have an emergency fund, slush fund, and retirement accounts already saved, then make sure your monthly payment fits in your overall budget.
For some purchasers, a 20% down payment seems like too much. For others, it is not enough. Putting at least 20% down allows you to eliminate additional expenses, such as private mortgage insurance (PMI), that you would otherwise have to pay. It’s important to give yourself a financial cushion to pay for other items in the home-buying process.
There are a variety of additional costs to consider outside of the down payment when buying a home. You will need to pay for a home inspection, homeowner’s insurance, loan origination fees, and more.
