Ideas for solving the 20% house downpayment dilemma

I asked a few friends of mine why they didn’t maximize the contributions to their 401(k) each year and the number one reason was that they were saving up money for a downpayment on a home. All of my friends are young professionals with good salaries but with your typical rowhouse in the area costing around $200,000 to $350,000, with many far more, it’s extremely difficult for someone to come up with the $40,000 to $70,000 required for 20% down. What’s adding to the difficulty is that it doesn’t even consider the closing costs which can get up to $10,000. So, what are some strategies you can use to come up with the 20%?

First, How Much Will You Need?

This is step one, calculating how much you’ll need to save in order to reach your goal of a 20% downpayment. After you have this target number, you can start employing the strategies below to figure out how you’ll get there. Let’s say you want to buy $300,000 of house in 2 years, so that means you have 24 months to save up the $60,000 downpayment. I think you can use a conservative estimate of 4% for the appreciation of your money in savings (let’s ignore inflation because the estimates for inflation and its effects over two years are too variable to use historical numbers).

Ideas for SolvingNow, calculate how much you’ll need to save over 24 months to reach $60,000. Here’s a savings calculator (you will need Java installed, but it should ask if you don’t have it) that you can play with to reach your answer (I used a business calculator). Enter in $60k for the savings goal, 2 for the years to save, and all the other pertinent data. If the graphs aren’t updated, click on the Calculate button. The answer is $2,375 (the white boxes). You can enter in your current savings to see how far away you are, but $2,375 is your target number each month if you want $60k in 2 years at 5% appreciation. So, how do you get there?

Find A Smaller House, Different Location

Now that you have the target number, it’s time to play with it. While this sounds like a no-brainer, it isn’t that clear when you’re searching around for homes that you should settle for less house. What used to be a “starter home” in an area ten years ago is no longer a starter home as home prices, even after the recent slipping, have vastly outpaced inflation and wages. In your mind’s eye you have an image of what you’re first home was going to be, I know I had an image of a first home that looked like the home I grew up in (my parents still live there and have done so for the last 27 years). The problem was that home is at least half a million dollars in the nicer areas of Maryland, if not more depending on the home’s age and specific location, so it wasn’t within reach.

Next step? Think townhouse. Single family home on my salary was an impossibility unless I was willing to sacrifice other factors such as the location, which I wasn’t, so a townhouse was my next option. If you’re a handyman or handywoman, consider getting a fixer-upper. If you’re not picky about the location, pick a less desirable location. Ultimately the first step is finding out how little you’re willing to pay for a home and how much you’d be willing to pay and check out your options.

So, let’s say you are now willing to live in $200k worth of house and thus need only $40k in a downpayment in two years. $1,583 is now your target savings per month, a difference of $792 each month.

Ask Your Parents (Relatives, Grandparents, Etc)

This is how I was able to come up with any type of downpayment (I was only about to get around 10%, even with my parent’s help) and it’s something that requires a little of preplanning because of gift taxes. The donor must pay gift tax on any gift over $12,000 in 2007, so if your parents can help then it will help their tax situation to spread the gift out over the years. If you do this, keep this sample gift letter template in your back pocket because you’ll need to send a version to your lender when you request a mortgage.

Let’s say you’re back to a $300,000 house and your parents (or benefactor) gives you $10k right now. Enter that as your “Amount currently saved” in the tool and you’ll find that your magic number per month has fallen from $2,375 to $1,939, or a difference of $436 of savings each month.

Cut Back On Retirement Savings

This is another option that I and many of my friends did to help save a little extra. I still put in my maximum Roth IRA contribution and the minimum needed to get the employer match for my 401(k), but I didn’t contribute any more to retirement outside of what I consider the bare minimum. Some might not even contribute to a Roth IRA, but I would consider that a mistake. At this point you’ve stopped reducing the magic number and started focusing on increasing your savings, so it doesn’t make much sense to look at the calculator anymore.

Cut Back On Discretionary Spending

Start finding trimmables in your budget so you can get your savings up to your target savings rate to achieve your goal. The trimmables post I wrote back in October of 2005 still applies today and it was motivated by my own savings plan when I bought a house. It’s easy to cut something back when you think it’s only temporary and when you have a goal in mind.

I hope that with a little bit of math and some suggestions I’ve been able help some prospective homebuyers wrap their heads around where they can look to get that 20% downpayment, it was the approach I took and it ended up working for me so I hope it works for you. If you have any suggestions or ideas that I’ve missed, please let me know and I’ll add them to the list. I hope that this helps people understand that while getting 20% is difficult, it’s not impossible if you’re diligent.

Agree on finances before you get married

finances before you get marriedThe sooner you and your spouse can agree on where the family money goes, the better. The best time to figure out finances is before you’re married when both of your money is separate.

I’m getting married in October. The shared finances discussion has begun. It will continue for the next few months until we’ve covered all of the ground rules. These premarital financial discussions should minimize the fights while we’re married.