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Saving for a Down Payment on a House?

A conventional mortgage generally requires the buyer to have a down payment of at least 5% of the purchase price. A Federal Housing Administration (FHA) loan requires a minimum of 3.5% downpayment. However, if you put down less than 20% of the full purchase price on either loan, you are required to also buy private mortgage insurance (PMI) on conventional loans—this is mortgage insurance premium (MIP) for FHA loans. This insurance generally adds between 0.5% and 1% of the loan amount onto your house payment annually. Also, it continues—in most cases—until your loan value is paid down to 80% or less.

It is best to have a down payment of 20% to get the lowest possible loan interest rate and avoid the need for private mortgage insurance. That's a lot of Benjamins when you consider the price of houses. But how can you get started on saving tens of thousands of dollars for this purchase?

How Much Should You Save for a Down Payment?

Ideally, you should try to save up a 20% down payment to avoid the additional cost of mortgage insurance and have equity in your new house right from the get-go, but that can be a daunting task. For instance, with a home priced at $200,000, you are looking at coming up with $40,000 just for the down payment, which doesn't include closing costs or other expenses related to securing a mortgage and buying a house. The good news is that this down payment doesn't go anywhere. It's sitting in your house, and when you sell, you get it back as part of your equity.

Though 20% of the purchase price should be your goal, you don’t have to let the 20% rule keep you from owning a home. Sometimes putting down a smaller down payment could be the smarter option. Each situation should be weighed on its merits and a decision made based on both short-term and long-term issues.

If you are comfortable with a down payment lower than 20%, check with the Federal Housing Administration or Veteran's Administration as well as state housing authorities for programs that can offer first-time and low- to moderate-income families a lower down payment requirement than conventional loans. The U.S. Department of Housing and Urban Development offers resources to help low-income and single parents to obtain a mortgage and buy affordable homes. The U.S. Department of Agriculture’s Rural Housing Service also offers a program intended to encourage low-to-moderate-income buyers to purchase in rural areas.

Saving Cash for Down Payment

Typically the down payment comes from a source of cash savings. If you are going this route, figure out how much you can comfortably save every month toward a house and then calculate how long it will take you to get the amount you need for a down payment on the kind of house you want. Figure out the time frame based on coming up with various percentages of down payment and how much difference those scenarios would make in your monthly payment. Then adjust your savings or your time frame as needed. It's important to have a plan and then stick to the plan.

For example, say that you want to buy a house that costs $200,000. If you want to put 20% down, you would need $40,000. If you saved $1,000 a month, it would take you three years and four months to have the down payment. If you wanted to put 10% down, you could round up that amount in half the time. Figure out the best plan based on your circumstances.

You want your money to be working for you while you are saving. Money that is sitting in a regular savings account earns very little interest and won’t help you reach your savings goal faster. 

  • Look into a high-yield savings or money market account for holding the down payment funds. You generally get a bit more interest in these accounts than you do in a regular savings account.
  • Check out a certificate of deposit, called a CD. You have less flexibility and liquidity with these accounts, but the principal protection and yields can be attractive when compared to a typical savings account.

Retirement Plans as Sources for Down Payments

If you currently have money saved in retirement accounts, they might be able to be tapped. Some 401(k) and 403(b) retirement plans allow participants to borrow money from the account for a new home purchase. Additionally, if you have an IRA account, you can withdraw money for a house if you are a first-time homebuyer. 

Unlike other loans, a 401(k) loan will not count in your debt-to-income ratio when you apply for a mortgage, and it will not affect your credit score. That said, there are some big consequences if you fail to repay the loan. These include paying income taxes on the amount you borrowed and possibly an early withdrawal penalty of up to 10%. And if you leave your job while in repayment of your 401(k) loan, you may only have 60 to 90 days from termination to pay it off completely.

The other costs of such a loan are the opportunity costs. How much growth on your retirement assets are you missing out on by borrowing that money? These are all considerations that must be thought through, including if you can pay back the loan along with the new mortgage, even if the lender does not consider this debt in the qualification process.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.

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