What Is a Down Payment?
Let’s start with the basics. A down payment is the cash you bring to the closing table when buying a home. You may borrow money from the bank in the form of a home loan or mortgage, but a portion of the total cost must come directly from you.
Here’s why: The down payment acts as an insurance of sorts for your lender. When you hand over money from your own account, you’re officially invested. You’re more likely to make good on your mortgage payments month after month and year after year. Banks like working with folks like you.
By saving up for a down payment, you not only prove yourself to a lender, but you also set your own mind at ease. A sizeable down payment reduces your monthly house payment, allowing you to choose a shorter mortgage term so you can say goodbye to this debt sooner rather than later.
How Much Should I Save for a Down Payment?
It’s no secret that we don’t like debt. That’s because car loans, student loans and credit card debt can tie up our income, leaving us with less money for the things we really want to do.
So how much should you save? That’s the million-dollar question! But don’t worry. You won’t need anything close to one million dollars to set yourself on the right track for buying a home. However, you do need to work through the process below to arrive at your magic number.
We’ll use an imaginary family—the Clarks—in our example.
1. Determine how much you can afford each month. The rule of thumb is to spend no more than 25% of your monthly take-home pay on your mortgage payment. If you tie up too much of your budget in your monthly payment, you leave yourself unprepared to face emergencies or embrace opportunities. We find that 25% (or less!) is the sweet spot.
For the Clarks, 25% of their monthly take-home pay equals $1,050 each month. Keep in mind that this number should include taxes and insurance, escrow, and homeowner association fees.
Do the math: Write down how much money you (and your spouse, if applicable) bring home each month. Multiply this number by .25 to find your monthly mortgage amount.
2. Use your monthly mortgage payment to arrive at a total mortgage amount. Let’s play around with Dave Ramsey’s Mortgage Calculator to see what price range the Clarks should stick with.
When it comes to the type of mortgage you select, we recommend a 15-year fixed rate, which is guaranteed to save you tens of thousands of dollars compared with the traditional 30-year option.
We know the Clarks have $1,050 to spend on their monthly mortgage payment. Using the mortgage calculator and its set interest rate of 3.66%, we discover that they can purchase a $145,000 home with a 20% down payment, a $130,000 home with a 15% down payment, or a $125,000 home with a 10% down payment.
Do the math: Spend some time on our mortgage calculator. Input different numbers into the home value and down payment section with the goal of hitting your preferred total monthly payment. Make note of your options and talk things over with your spouse, a trusted friend or family member.
3. Aim for between 10% and 20% for your down payment. If you haven’t already, hone in on the percentage that works best for your family. Ideally, you’ll choose to put down 20%, which can lower your interest rate, open you up for a 15-year mortgage, and help you avoid private mortgage insurance (PMI).
Let’s assume the Clarks decide to put down 20% on a $145,000 home. That means they’ll need to set aside $29,000 for a down payment.
Do the math: Multiply the total mortgage amount by the percentage you plan to put toward the purchase of a home. Now you’ve got your savings goal! Circle it, post it on your fridge, and get ready to start saving!
What Other Costs Should I Consider When Saving for a Down Payment?
Remember how we acknowledged that lenders aren’t exactly our best friends?
Spoiler alert: Banks don’t just expect a down payment. They also require you to pony up for other fees that might feel hidden if you don’t know about them ahead of time. Let’s cover those now, shall we?
Private Mortgage Insurance (PMI)
Short for Private Mortgage Insurance, PMI is a fee tacked on to your monthly mortgage payment if you put down less than 20% on your home. You can count on PMI upping your monthly payment by about $50 for every $100,000 you spend on a home.¹
Appraisal and Inspection Fees
In order for your lender to sign off on your mortgage, you’ll need to have your future home appraised and inspected. Each of these can cost just over $300 on average.²³
A lot of work goes into signing on the dotted line. And unless the seller agrees to pick up the tab, you’ll be responsible for fees between 2% and 5% of the total mortgage value.⁴
Our imaginary family, the Clarks, already plan to save $29,000 for a down payment of 15%. And now that they’re in the know about the “hidden” fees of buying a home, they’ll need to set aside a bit more to cover them. Time for more math!
The Clarks purchase a $145,000 home with $21,750 down.
Their mortgage amount equals $116,000.
The cost to cover the first month’s PMI at closing is $65.
An appraisal and inspection equal $600.
Fees from closing costs could be as much as $5,800.
In addition to the $21,750 down payment, the Clarks should set aside an additional $6,465.
And, if the Clarks get lucky and the seller agrees to cover closing costs, that leaves them with a good chunk of money to put to good use elsewhere.
When Should I Buy A Home?
When buying a home, it’s not just about how much you spend, it’s also about timing. How will you know you’re ready?
We follow the Baby Steps for true financial peace. With this method, we first set aside $1,000 as a beginner emergency fund. Then we pay off all non-mortgage debt with a vengeance, followed by beefing up our emergency fund until it reaches between three and six months of expenses.
Once you tackle these first three steps, you’re ready to buy a home. Here’s why:
You won’t have to slow your debt payoff schedule to save for a down payment, allowing you to be debt-free much sooner.
You’ll be prepared for the inevitable emergencies that come with home ownership.
You’ll have room in your budget to move through the remaining Baby Steps:
Trust us, get the timing right and all you’ll need to worry about is what to do with that pink tile in your new bathroom.
How to Save for a Down Payment
Start with a smaller number.
Does that big, looming down payment goal overwhelm you? Divide it up! Decide when you’d like to buy. How many months away is your goal date? Simply divide your needed down payment by the number of months you have to save.
Our imaginary Clark family wants to save $34,465 to cover a down payment and all closing costs of purchasing a new home. They’d like to buy a home in two years, so they’ll need to save $1,478 each month to hit their goal.
Because the Clarks are following the Baby Steps, they have no debt, already saved six months of expenses, and have some flexibility in their budget to sock away a lot of cash each month.
Creative Ways to Save for a Down Payment
If you do the math and find that your monthly savings amount is just too high, that’s okay. Give yourself a little more time to save up and be on the lookout for creative ways to save. Here are some suggestions:
1. Set up a Down Payment Fund.
First things first: Once you figure out what you should save each month, create a fund in your EveryDollar budget to track your savings and reach your goal.
2. Throw extra money toward your Down Payment Fund
Look for ways to trim your budget so you can put more toward your down payment. Here are a few ideas:
Pack your lunch
Make coffee at home
Cancel gym memberships
Start a side business
Get a second job
3. Store your down payment savings the smart way.
There will come a time, probably about halfway to buying a home, that you (or your spouse) will be tempted to take a spontaneous trip to Europe with your savings. Trust us, it happens.
To protect yourself from yourself, don’t store your down payment money in your regular bank account. Try a separate savings account or a money market account instead.