Saving for a home or, more precisely, how to save for a home is today’s Q & A.
You: Q & A?
Although Friday comes every week, Friday Q &A comes around only when someone submits a good question AND I have time to answer it. Both happened this week, so here we go. Want to ask a question? Click here for more information or simply email a question.
I would like to know what is the most effective way to save for a home? I am currently putting the matching percentage of my employer into my 401(k). Should I open an IRA account or Money Market account to reach my goal of 20% down payment on a home?
I believe my income prevents me from getting a ROTH IRA but I am not sure about a traditional IRA.
Matt C.
I love when people ask questions like Matt’s, because it shows they’re committed to doing the right thing and simply want advice as to the best way to do it. Contrast Matt’s question with the infinitely more common, “Can I use my emergency fund (It’s almost $1,000!) to make a down-payment on this new car I want? I’d be getting a great deal!”
For anyone that has a matching program at work, taking advantage of said program is step # 1. Matt’s done that – congrats to him.
Now, Matt wants to know how to save for a home – an appropriate goal for most individuals. Have you paid off your high interest credit card debts? Do you have an emergency fund? If so, great. If not, go there first – those items are more important than the house. Seriously.
Once you’re ready to save for the home, I believe it makes sense to open a separate account (it can be at the same institution where you already have a relationship) that is earmarked for that purpose. Doing so makes it much more difficult for you to take the money out for some alternative purpose in the many months (possibly years) before you actually take the plunge into homeownership.
While others will argue that an IRA or a Roth IRA (each of which has some exceptions to taxes and penalties due on a pre-retirement distribution when the money is used to buy a home), I do not support this approach. Rather, create a regular taxable savings or money market account. The tax savings, particularly in this pathetic interest rate environment, from using a retirement account to save for a home will be negligible at best. More importantly, I prefer to think as retirement plans as exclusively available for retirement. If you tolerate one exception, why not another later on?
A retirement plan is to used for retirement. Keep your promise. It’s a promise you’re making to yourself, anyway!
How to Save for a Home – Account Specifications
Don’t put your money in an account that is not FDIC insured. Right now, there’s a $250,000 limit on insurance per account. There’s no reason to take on any risk with your down payment money.
Choose a bank that pays some freaking interest. While interest rates for savers are disappointing almost everywhere, there is still a meaningful spread between the least and most generous banks, a range that is likely to become more important when rates one day increase across the board. Internet only banks like ING DIRECT, HSBC, Emigrant Direct and others are great places to start. Bankrate.com lists the highest paying institutions.
Consider CDs. If you know you’re not going to buy a house for 6 months, a year, or even longer, consider CDs as a way to earn a bit more interest. I don’t suggest going too long, however, as you may not want to lock in your rate for, say five years at a couple of points, since rates may be much higher before your term is done.
Establish a realistic goal. Then achieve it. Do what you can to get a down payment of 20% of your purchase price, saving you the potential significant expense of mortgage insurance. (Matt’s 20% wasn’t picked out of thin air. It’s the goal all first time home owners should set for themselves). If 20% sounds like a ton of money, it probably is. But you’ll be more financial savvy for achieving that amount, as many home owners (and former home owners) have recently discovered. Banks too have re-learned the importance of a home owner have a financial stake in their home.
Good luck Matt. Stay in touch and let us know what you decide to do.
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Anyone else planning on buying a home soon? My wife and I still are, although we haven’t updated you on our progress (or lack thereof) recently. More to come.
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Michael,
Do people typically need to save before buying a house? For example, our PMI is about $150/month. While that amount definitely adds up, in our area it’s much less than renting (avg $700-$900/month). In my mind, I’d rather be putting my money on a house, and handing someone else $150/month, than handing $700/month to someone and never seeing anything for it. Does this vary by region?
P.s. I’m in SC.
@D Wolfe: There’s a lot to your question(s). Sure, plenty of people save very little before buying a home and pay PMI. The relative attractiveness of rent vs. buying varies by geography and based on market conditions at the time you choose to investigate buying. Nonetheless, I wouldn’t compare the $150 to the $700 – $900, since your PMI is just one cost of owning and does not include the interest payment, real estate taxes, maintenance/upkeep, etc. Of course, there are upsides of ownership including possible appreciation and the emotional pride that comes with ownership.