Updated: Jun 26, 2020
Buying a house is a dream for millions of people. For these people, one of the most pressing financial questions they have is how to save enough money to buy a house?
Here are five essential steps to save for buying a house.
Determine if buying a house is the right financial decision.
Figure out if you are financially prepared to be a homeowner.
Find out the total amount of money you need to buy a house, including the down payment and closing costs.
Set a realistic goal for when you would like to buy a house.
Figure out how much you need to be saving each month by dividing the total amount of money you need to buy a house determined in step 3 by the number of months determined in step 4.
In this post, I’ll examine each of these five steps in detail plus offer a few tips that can tilt the numbers in your favor and prevent your dream of homeownership from becoming a nightmare.
Step 1: Determine if buying a house is the right financial decision
Before you start saving for that down payment, the first thing you need to do is make sure that buying a house is a better financial decision for you at this time then renting.
Many people skip this step entirely under the belief that owning a home is always a better financial decision than renting. Don’t fall into this trap. There are certain circumstances where renting is a wiser financial decision.
Whether or not it makes sense to buy or rent will depend on the cost of owning a home compared to the cost of renting a comparable home in your real estate market.
The rent vs. buy decision
Here is how a lot of people look at the rent vs. buy decision.
They look at the cost of renting a home.
Then they compare the monthly rent to the monthly mortgage payment they would have if they bought that home.
If the monthly mortgage payment is lower than the cost of rent, they decide to buy.
While comparing a mortgage payment to rent feels intuitive because they are both monthly, housing costs you need to include more than your mortgage payment when comparing the cost of owning a home to the cost of renting.
The 5% rule
Ben Felix, a Portfolio manager in Ottawa, Canada, came up with a rule of thumb to look at the rent vs. buy decision, which he called the 5% rule.
The 5% rule attempts to compare the unrecoverable cost of ownership with the unrecoverable cost of renting a comparable home.
The unrecoverable cost of renting is simply your monthly rent.
The unrecoverable cost of owning is the interest paid on a mortgage, property taxes, and annual cost of maintaining the home.
The critical assumption in the 5% rule is that a renter would be investing the money they would have used as a down payment, and any money spent on the unrecoverable cost of owning a house, in the stock market.
How the 5% rule works
Multiply the value of your home by 5%.
Divide by 12.
The result is the breakeven point, where renting is financially equivalent to buying.
An example of the 5% rule
Let’s say you are considering whether to buy a $600,000 house.
You are multiplying the value of the home by 5% = $30,000.
Dividing that number by 12 = $2,500.
$2,500 is the monthly breakeven point for owning that home.
According to the 5% rule, if you could rent an equivalent home for less than $2,500, you are better off renting.
For more information on the 5% rule, you can read my full breakdown of it here.
Or better yet, why not watch Ben Felix explain it himself.
Step 2: Figure out if you are financially prepared to be a homeowner.
Once you have determined if the numbers make sense for buying vs. renting, the next thing you need to do is figure out if you can afford to buy and maintain a home given your current financial situation.
Beyond what you’ll need to save to buy your house (more on that soon), you’ll also need to budget for the annual cost of maintaining a home. Just because you can come up with the down payment does not mean you can afford a particular house.
I can’t stress that point enough. Owning a home is a substantial financial commitment. At a bare minimum, you need to budget for three significant annual costs of homeownership.
The mortgage payments.
Several factors determine the size of your mortgage payment.
Price of the home.
Size of your down payment.
Amortization (how many years will it take you to pay your mortgage off.)
The interest rate on your loan.
For property taxes and maintenance costs, a common rule of thumb is to assume each of these costs to be 1% of the purchase price of the home.
So, if you bought a $500,000 house, you would expect $5,000 in property taxes and $5,000 in annual maintenance costs.
If you think that is too much to budget for maintenance costs, do a few Google searches for what it costs to reshingle a roof, replace a furnace, or repair damages from a flooded basement.
Remember, this is an average; some years you might spend $1,200 on home maintenance, and other years you might spend $35,000.
How much house can you afford?
The term “house-poor” refers to someone who spends so much money on their housing costs that they can not afford to save any money. You want to avoid becoming house-poor.
One of the most frequently asked personal finance questions is how much of your income should you spend on housing costs? There is no magic number, but the most common advice from financial experts is to spend no more than 30% of your gross income on housing costs.
So, how much house can you afford? I’ve created the following table, which tells you how much of your gross income will be spent on housing, depending on the price of the home you buy.
Let’s quickly review the assumptions made in the above table.
Your mortgage rate is 3% on a 25-year amortization.
You have 20% of the home price available for a down payment.
Annual property taxes are 1% of the home price.
Annual maintenance costs are also 1% of the home price.
Annual utility costs, which include water, heating, electricity, trash, landline, and internet, are equal to the national average in the U.S at $2,060.
As an estimate, I used the average household income in the U.S in 2019, which was $89,930.
If the average U.S household bought a house for $437,500, they would expect to spend 34% of their annual gross income on housing, spending any more than that would move them closer to being considered “house-poor” as a higher percentage of their gross pay would be going to housing.
How you can quickly calculate if you can afford a particular house
To customize the above table to see how much of your gross income would go towards housing, here is how to do it.
Step 1: Google “mortgage calculator” and find out the estimated monthly mortgage for a house you are looking for. Multiply the monthly mortgage payment by 12.
Step 2: Add 1% of the purchase price for property taxes.
Step 3: Add 1% of the purchase price for maintenance costs.
Step 4: Add an estimate for the annual utility costs.
Step 5: Add the total from steps 1–4 and divide that number by your gross (pre-tax) annual income.
The result will tell you how much of your gross income you can expect to spend on housing costs each year if you buy the property.
If these costs of maintaining a home are too expensive, you may want to wait until your financial position improves. Remember, you still need to pay for food to put in the fridge, gas to put in the car, and leave some money left over to save. Owning a home is a great financial goal, but it should not come at the expense of all your other goals.
Step 3: Find out the total amount of money you need to buy a house including the down payment and closing costs
If you were surprised to learn how much it costs to maintain a home, you might be unpleasantly surprised to learn how expensive it is to buy a home. Let’s review all of the costs you should expect to pay when purchasing a home.
Down payment: How much money you need to have for a down payment depends on the price of the home and what percentage of the price you want to include in your down payment. If you’re buying a $500,000 house and want to put a 20% down payment, you would need $100,000.
Mortgage insurance: Most people don’t have $100,000 lying around, so they will likely have a down payment of less than 20%. In those cases, be prepared to pay mortgage insurance. In the U.S, it’s possible in certain circumstances to buy a house with only a 3.5% down payment. In these cases, you would apply for an FHA loan, which has an upfront insurance premium of 1.75% of the value of the loan paid at closing. Also, be aware that there is an annual mortgage insurance premiums that range from 0.45% to 1.05% of the loan amount.
Application fee: A fee charged by the mortgage company to process your application for a loan.
Legal fees: The cost to have a lawyer review all of the closing documents and agreements.
Escrow fee: Paid to the title company or lawyer who is handling the closing.
Home inspection: Often, buyers will pay for a home inspection so they can be made aware of any repairs that need to be done to the home.
Title insurance: This covers the cost to ensure that no other parties have an ownership claim to the property you are buying.
Transfer taxes: Depending on where you live, there could be a tax that you must pay when purchasing a property.
In total, closing costs, in addition to your down payment, could be anywhere from $3,000 to $7,500, according to a report from Zillow.
Step 4: Set a realistic goal for when you would like to buy a house.
This step is rather self-explanatory and straightforward, set a realistic goal for when you would like to be able to buy a house. Let’s say you want to be able to save for a house in two years.
Step 5: Figure out how much you need to be saving each month
If you wanted to buy a $500,000 house with a 10% down payment in two years, how much would you need to start saving if you were starting from scratch?
Obviously, you would need $50,000 for the down payment, and we’ll assume a total of $5,000 for all other closing costs for a total of $55,000.
You want that saved in two years or 24-months.
You would need to save $2,291.66 per month to reach that goal.
If, after doing this analysis, you find that you won’t be able to save that much each month, you’ll need to simply need to give yourself more time to save.
By extending the goal of saving $55,000 to buy a house from 24-months to 60-months would reduce the amount, you need to save each month from $2,291 to $916.
Another common question is where people should keep the money they are saving to buy a house. This is simple. Any money that you will need in the short term, including money being saved for a down payment on a house should be kept somewhere that is entirely risk-free. Never invest short-term money in risky assets.
Buying a home can be a fantastic achievement
Buying a home is a significant financial milestone, but it is also an incredible responsibility. You’ll need a lot of money to not only buy a home but maintain it. You need to make sure you are in a strong enough financial position to handle that responsibility.
The first step is to look at the costs of renting vs. the cost of owning a home in your market. It is not always the case that owning a home makes more sense than renting.
Next, It’s important to ensure that you will have enough income to pay the annual costs of owning a home without becoming house-poor.
Before you start saving, you’ll need to know how much you need to save to buy a home. That includes both the down payment and all closing costs. Once you set a goal for when you would like to buy the house, you’ll have everything you need to figure out how much you need to save each month. Simply divide the total amount of money you’ll need to buy a house by the number of months until you want to buy that house.
You can make the dream of homeownership a reality. All you need is careful planning and patience.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.