Balancing Act: Down Payments and Cash Reserves

December 15, 2014 | By

If there were ever a video game made about the homebuying process — in which the game’s hero goes from dreaming of buying a home to actually owning one — saving enough for the down payment would be like clearing the first level.

Much like the well-worn mantra about how finding a new home could be boiled down to “location, location, location,” the finances behind a new home boil down to three other considerations: budget, budget, budget.

For many, buying a home is an emotional purchase. People fall in love with houses, but homebuyers need to avoid falling head-over-heels. The key to keeping a level head is to ask yourself questions such as:

  • Is this a home that I can afford over the long term?
  • Will I have enough income and cash in reserve to make all my various monthly payments in the future?
  • What percentage of down payment should I actually make?

Many would-be homebuyers have had to wait until they had saved up enough for a sizeable down payment to get a loan, even though they may have had great credit scores and strong incomes. But some recent policy changes by Fannie Mae, Freddie Mac and FHFA have affected access to credit. Responsible lenders are able to give qualified borrowers an affordable and sustainable loan with a 3 percent down payment, making owning a home a possibility for many who aren’t being served by the market.

But making a smaller down payment doesn’t change how you should budget for ownership over the long haul. Having enough income and cash on hand for the ongoing costs of owning a home are key to preventing a new homeowner from suddenly becoming “house poor.”

Here are some things to keep in mind when deciding what kind of down payment you would like to make:

  • Figure out your net income. Your net income is the amount of your take-home pay once taxes and other deductions are taken from your paycheck. To better calculate what your net income will be for the year, first look at the frequency at which you are paid. For instance, if you’re paid weekly, multiply your take-home pay by 52. If you’re paid monthly, multiply your take-home pay by 12. The final result will be the amount of money you will have on hand to spend each year on your home and other expenses.
  • Break down your fixed and variable costs. Your fixed costs are those expenses that cost the same amount each month, such as health insurance, car insurance, and — yes — mortgage payments. Variable costs cover both necessary expenditures (like groceries) and not-terribly-necessary expenditures (like lattes from your local coffee shop). These are expenditures you can essentially control, as there is no fixed cost each month. For instance, if you stop buying cookies and tortilla chips during your grocery trips, you may save $100 or so over the course of a year (while keeping your waistline at bay in the process). The more money you can save by cutting down costs can be redirected towards your housing costs.
  • Break down the new expenses you will incur once you officially own your home. Property taxes, homeowners insurance, homeowners’ association dues, garbage collection fees, water bills — these are just some of the many new expenses you may be introduced to once you purchase your first home. If you make a down payment of less than 20 percent, you will likely have to pay private mortgage insurance (PMI), which can cost upwards of $70 per month for every $100,000 borrowed on your mortgage. Fannie Mae advises that homebuyers pledge no more than 28 percent of their income on housing costs.
  • Save for emergencies. With a lower down payment, some of that money can go into other things, like seeding college savings or retirement funds. But it’s critical to have cash reserves on hand for a safety net to deal with unpleasant surprises like big maintenance expenses or a change in employment status.

Making a lower down payment may be an affordable option for a whole new group of aspiring homeowners, but those buyers need to make wise decisions too. A lower down payment will likely mean a higher monthly payment. There will be new costs, like mortgage insurance, and new homeowners need to be prepared for new expenses, some of which will change from month to month.

There’s a lot to keep in mind when searching for the right balance, but more choices mean there are more opportunities for responsible buyers to own and live in a home they can love.

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