How to Save for Your First Home As Buying One Gets Tougher

With today's lofty housing prices, purchasing even a 'starter home' can mean saving tens of thousands of dollars for a down payment. We offer several suggestions that may make the path to home ownership a bit easier.
By: Kelly K. Spors: The Wall Street Journal Online
It's a dream of many young adults to buy a first home. But there's an unfortunate reality: Even buying a "starter home" with today's lofty prices can mean saving tens of thousands of dollars for a down payment.

How do you pull it off? The key, obviously, is to save like crazy. Beyond that, here are several suggestions that may make the path to home ownership a bit easier.

1. Aim for 20% down.

Timothy Wyman of the Center for Financial Planning in Southfield, Mich., says you may be able to get by with putting only 10% of the purchase price down, as long as you are confident your income will remain steady or grow and you plan on keeping the home at least five years.

But Mr. Wyman says buyers should ideally aim to save up 20% or more of the price. The risk of putting down too little: If the home falls in value and you sell at a loss, you'll owe more to the lender than you receive from the buyer.

In addition, many mortgages require buyers who put down less than 20% to get private mortgage insurance, which can add $80 to $100 to your monthly bill. And the less you put down, the higher your loan balance and therefore your monthly payment will be.

Mortgage lender Washington Mutual estimates that a buyer who puts down 5% on a $300,000 home with a 5.88% 30-year fixed-rate mortgage might pay $2,133 a month, including fees and property tax, while a buyer who puts 20% down would likely pay $1,682 a month. (The estimate assumes the 5%-down buyer must pay for mortgage insurance.)

You'll also need extra money set aside on top of the down payment for closing costs such as title insurance and mortgage fees, which can reach up to $5,000. If you want to pay "points" to lower your mortgage rate - a smart idea for borrowers who expect to stay in a home several years - you'll want a few thousand dollars more.

To find out the price of local starter homes, so you can estimate what you'll need to save up, you can check out home listings on Realtor.com or compare sales data at Zillow.com.

2. Keep it separate.

Set up a separate account for your down-payment funds, so the money doesn't get intermingled with other savings and so you can keep track of how much you save. This would probably be a taxable account at a bank or brokerage firm.

Mr. Wyman suggests setting up regular automatic deposits from a checking account into the down-payment account to force regular savings. "You want to be moving money to this account before you spend it," he says.

3. Consider your time horizon.

How best to invest down-payment money depends on your time horizon for purchasing a home. Those planning to buy in three years or less should put the money in conservative investments such as short-term certificates of deposit or short-term bond mutual funds to shield themselves from potential market downturns.

If you're waiting at least five years to buy, you can invest more aggressively. A balanced mutual fund that invests in, say, 60% stocks and 40% bonds, such as Vanguard Balanced Index Fund, is a good choice and should perform better over the longer period.

4. Get extra help.

Few first-time buyers pony up the entire down payment on their own. Nearly 23% of first down payments come as gifts from relatives and friends, according to a recent survey by the National Association of Realtors.

While such assistance is great, there are also other places you can look. There are many down-payment assistance programs for first-time buyers that are offered by banks, local governments and charities. Many are open only to low- or moderate-income buyers and some are targeted to specific communities.

Some programs lend buyers a substantial portion of the down payment. For example, the California Housing Finance Agency can provide eligible first-time home buyers in Los Angeles 3% of a home's purchase price as down-payment or closing-cost assistance. The money must be repaid when the buyer sells the home, refinances or pays off the loan.

Many lenders have information about assistance programs that borrowers can seek help from.

5. Clean up your finances.

Your credit history will determine the loan terms and mortgage rates you qualify for. You could be offered a smaller loan or charged a higher rate if a lender is concerned you might not be able to repay.

So before approaching lenders, first-time buyers should give themselves the financial equivalent of a physical exam, says Ellie Deskin, a financial planner in Troy, Mich. This means checking your credit score and credit reports with the three major credit bureaus and fixing any errors. (Consumers can now get one free copy of each report annually by going to Web site annualcreditreport.com.)

Also consider paying down some debt, especially high-interest debt such as credit cards, that might flag you as a riskier borrower.

While some debt is okay, being overloaded will likely tarnish your loan terms.

6. Weigh mortgage tradeoffs.

Lenders increasingly offer creative loans, such as interest-only loans and certain types of adjustable-rate loans, that can reduce your monthly payments - at least for a while. But these alternative loans can be much riskier than fixed-rate loans, because monthly payments can jump after a few years.

A general rule of thumb is that your monthly mortgage payment shouldn't exceed 28% of your household's gross monthly income. Check out some mortgage calculators at Dinkytown.net to calculate what your monthly payment would be with different types of loans.

7. Hands off retirement savings.

If you're just shy of saving up enough for a home, you might consider taking a small loan from your 401(k) plan or withdrawing some principal from a Roth IRA. But many financial advisers caution against tapping retirement accounts too heavily for a home purchase.

For one thing, you're going to need your retirement stash, so you don't want to gouge it. Taking a loan from your 401(k) can also be risky, since you may have to pay it back if you leave the company. And if you take money out of your Roth, you can't replace it, so you lose some of the Roth's long-term benefit of tax-free earnings.