Welcome to NerdWallet’s SmartMoney podcast, where we answer your real-world money questions — in 15 minutes or less.
This week’s question is from Henry. He says, “I’m wondering how to best save for a down payment on a house. I just got my first job and after contributing to my 401(k) and Roth, I have enough money to start saving for a down payment. I have decided to live with my parents for the next two years and they have generously agreed not to charge me rent, so I can save for a house. As a result, I don’t necessarily need to access the majority of the money I’m saving for the two years. I’m wondering how to best maximize this money. Should I put some of it into a CD for two years or would it be better put into a high-yield savings account? There doesn’t seem to be too much difference in APY at the moment. I just want to make my money stretch as far as possible.”
Henry can’t afford to take much risk because he’ll need the money within two years. A high-yield savings account from an online bank is probably the easiest option to get some return while keeping the money FDIC insured. Certificates of deposit are similar, but Henry would want to make sure the CDs all come due at the same time (in two years), even though he’s buying them at different times as he saves. A third option to consider is cash management accounts, which are a higher-yield option offered by some brokerages.
Since Henry’s a first-time home buyer, we also have some advice for figuring out how much house he can afford and how much of a down payment he needs. The old rule of thumb says you can pay 2½ to 3 times your income, but that doesn’t take into account any of your other obligations, such as student loan payments, says Holden Lewis, NerdWallet’s authority on mortgages and real estate. NerdWallet’s home affordability calculator can help Henry see what’s a reasonable amount for him to pay for a home, what’s a stretch and what’s truly aggressive.
How much cash you contribute to the deal also helps determine what you can afford, but the days when you had to cough up a 20% down payment are long gone. Most first-time homebuyers put down 5% or less, Lewis says.
That means you have to pay mortgage insurance. So the next decision will be whether to get a conventional mortgage, with private mortgage insurance, or a Federal Housing Administration loan. If Henry’s credit scores are below 720, an FHA loan is best, Lewis says, and the minimum down payment is 3.5%. With scores of 720 or above, private mortgage insurance will be cheaper than the FHA loan. There are some first-time home buyer loan programs that allow down payments as small as 3% with private mortgage insurance, Holden says.
Set your goal. Determine how much money you’re saving and how long you have to save it. Use NerdWallet’s home affordability calculator to help you figure out how much house you can buy and what kind of down payment you’re going to commit.
Do what it takes. If you need to live with your parents for a while to meet your financial goal, whether it’s paying off debt or saving up for a house, don’t let any shame or social stigma get in the way.
Shop around for the best accounts. Traditional banks offer a fraction of what you could earn with a high-yield savings account from an online bank or a certificate of deposit. A cash management account, offered by some brokerages, could be a good option as well for earning more interest.
Sean Pyles: Welcome to the NerdWallet Smart Money podcast, where we answer your money questions in 15 minutes or less. I’m your host, Sean Pyles.
Liz Weston: And I’m Liz Weston. Hey, we’d really like to get your questions, so you can send them via text or via phone call to the nerd hotline at (901) 730-6373. That’s (901) 730-NERD. You can also email us at email@example.com.
Sean: And you can even send your voice memos to that email address if that’s easier for you. Let’s get to this episode’s question, from Henry. He says, “I’m wondering how to best save for a down payment on a house. I just got my first job and after contributing to my 401(k) and Roth, I have enough money to start saving for a down payment. I have decided to live with my parents for the next two years and they have generously agreed not to charge me rent, so I can save for a house. As a result, I don’t necessarily need to access the majority of the money I’m saving for the two years. I’m wondering how to best maximize this money. Should I put some of it into a CD for two years or would it be better put into a high yield savings account? There doesn’t seem to be too much difference in APY at the moment. I just want to make my money stretch as far as possible."
Liz: OK. What Henry is running into is what every investor runs into, which is the trade-off between risk and return.
Sean: Right. That can be pretty tricky to balance, especially when you have a very specific deadline of, here in Henry’s case, two years. So to help answer Henry’s question, in this episode of the NerdWallet Smart Money podcast, we’re talking with home buying Nerd Holden Lewis about how big a down payment you might need to save for, which can help you set your goal, Henry, and then we’ll talk about which accounts can get you there faster. And at the end, we’ll wrap up with our takeaway tips so you can put all of your newly acquired knowledge into action. Let’s get to it.
Liz: Welcome back to the podcast, Holden.
Holden Lewis: Hey guys, I’m so glad to be back.
Sean: Hey Holden, good to talk to you again. Let’s just dive in and let’s start at the beginning of the home buying process, which is really figuring out your budget, how much house you can afford, and then how much of a down payment you might need for that house. So Holden, how do you think people should figure out how much house they can afford?
Holden: Well, there’s this rule of thumb that says that you can afford to pay between two and a half and three times your annual income. But the problem with rules of thumb is that they’re not always accurate. And that’s, especially in this case, if you have high debt payments each month that basically crowd out the amount of money you have available to pay your mortgage. So I recommend using a home affordability calculator. We have a good one at NerdWallet. You tell it your annual household income, your monthly debt payments, and it tells you roughly how much you can afford to pay for a home. And then you can refine the results. You can tell it your credit score range and how much you’ve saved for a down payment. This calculator will even tell you what’s an affordable home price, like what ideally you would pay for a home as far as being able to afford it. And then it’ll also tell you what’s a stretch and then it’ll also tell you what’s aggressive, quote unquote, which probably is not a really good idea to pay that much.
Sean: You can find that calculator on our show notes post at nerdwallet.com/podcast. But that’s a pretty important note in terms of just playing around and seeing what is and isn’t within your budget because these numbers can seem pretty nebulous and also very, very big. But having them in front of you on a computer screen can help them feel a little bit more real.
Liz: Part of the calculation is how much of a down payment he wants to make. It doesn’t need to be 20% anymore. People think it does, but that hasn’t been true for a long time. So Holden, how much of a down payment do you think he should make?
Holden: All right, so Henry says that this is his first job, and so I assume that he’s not a veteran or in the armed forces, because if he were a veteran or if he were in the armed forces right now, he could get a VA loan, and the minimum down payment on a VA loan is zero. And I highly recommend VA loans to people who are eligible. They are a great deal. All right, so let’s say he’s not going to be able to get that. Most first-time home buyers, they put down a lot less than 20%. Heck, they even put down less than 10%. If you put down less than 20%, you have to pay mortgage insurance, and so that is where Henry’s credit score comes in. If it’s below 720, his best bet is to get an FHA loan. That’s a mortgage insured by the Federal Housing Administration. And the minimum down payment on an FHA loan is 3.5%.
With an FHA loan, you pay monthly premiums of mortgage insurance, and those premiums are the same regardless of credit score. On the other hand, premiums for private mortgage insurance vary based on the credit score. Now, if Henry’s credit score is 720 or higher, private mortgage insurance is going to be cheaper than the FHA. There are some first-time home buyer loan programs that allow down payments as small as 3% with private mortgage insurance. Basically, the bigger your down payment, the better because a big down payment means that you get a smaller loan and lower monthly payments. But most first-timers make small down payments on the order of 5% or less.
Sean: OK. With this big savings goal we’re talking about, are we assuming that Henry is putting every penny he can into the down payment? I’m just thinking that he should probably have some money left over for emergencies and repairs and things like that. Right?
Liz: Homeownership can be stupidly expensive. One of my friends used to joke that everything that went wrong with this house cost $3,500. I’m in LA, so everything that goes wrong cost $6,500. It’s ridiculous. But it’s a really good idea to have at least two months’ worth of mortgage payments in savings after you buy a house, after you’ve paid the closing costs. If you have three months’ worth of mortgage payments, that’s even better. Six months is ideal.
Sean: Which is why it’s a really good thing that Henry has a couple of years to save up because you’re not going to build these cash reserves overnight. So the next step is figuring out how much you can contribute to an account of some sort monthly to hit the savings goal. And from there, Henry can extrapolate how long it might take him to save that amount.
Liz: So Sean, do we know if the two-year timeline is Henry’s or his parents’?
Sean: That’s a good question, and we don’t know the answer to that. But one thing I think Henry should think about is if that’s his own timeline, he might want to think about whether there’s some value in extending that. Because if he has an extra six months or a year to save up a down payment, that could mean lower monthly mortgage payments. That means he could possibly build a bigger emergency fund. All around, that time you spend staying at home, yeah, it might not be the most fun. He might really be hankering for his new house. I think it could pay off a lot in the long run.
Holden: So I’m going to address Henry directly now. Henry, you’re grown up, you’re living with your parents and I’ll bet you’re wondering if your co-workers, your friends and family look down on you for not living on your own soon after getting your first job. And if you’re single, what will potential romantic partners think? So, I mean, you’re human. You’re going to care what other people think of you, but also pay attention to your inner voice that uses the word “should," voices that say you should be living on your own. You shouldn’t rely financially on Mom and Dad. Just question those voices. Are they telling you the truth or not? Those inner voices that are lying to you are also shaming you. So look, I just want to say I’m not making fun of you, neither are Liz or Sean. I think your plan is great and hold your head high.
Liz: It can really help save money to live at home. Is there still a stigma attached to that, Sean?
Sean: In this market? I really don’t think so. I remember when I was living in San Francisco, I had a handful of friends that were living with their parents out in the surrounding suburbs and yeah, I mean we would laugh a little bit that they had to go back across the bridge when the night was over, but we knew in our heart of hearts that we were actually super jealous that they weren’t spending 1,300 bucks a month minimum for their apartment. That’s a lot of extra money in their pockets and we were jealous of that. I don’t think there’s a ton of stigma because it’s just a smart financial move, really.
Liz: OK. Now we can finally turn to the crux of Henry’s question, which is what’s the best way to maximize his money? One of the hard and fast rules is that you can get excellent returns or you can keep your money safe, but you can’t do both at the same time. There’s always a trade-off. You’ll get the best returns over time investing in stocks, but we know from the Great Recession that stocks can lose half their value or more in a downturn. They’re not a good choice if you need the money within the next few years because you don’t have time for your money, for your investment, to recover from something like that. I think you need to be able to leave the money alone for 10 years or more if you’re investing in stocks, particularly now. So instead, Henry should be prioritizing safety. That means FDIC-insured accounts, so he won’t lose his principal, but he doesn’t have to settle for a quarter of a percentage point or whatever his bank is paying.
Sean: Yeah, a really easy go-to is a high-yield savings account. Here we have a roundup of the best of at NerdWallet, and you can find the link to those on our show notes post at nerdwallet.com/podcast.
Liz: Henry also asked about certificates of deposit, so we should talk about those as well. Certificates of deposit give you a slightly higher interest rate if you lock up your money for certain periods of time, three months, six months, 18 months, two years, five years, whatever. So if he wanted to try that approach, he would need to make sure that the certificates of deposit basically mature at the same time. So, two years down the road. Another option is cash management accounts. These are offered by brokerages and they’re kind of a hybrid between savings accounts and checking accounts, so they pay a slightly higher interest rate. At some of them you have check-writing privileges, so you can actually get access to that. That might not be the best fit for Henry because he won’t need to touch this money, but it’s something to look into.
Sean: And with each of these options, it really comes down to the risk-return timeline thing we were talking about in the beginning of the episode. So I would really implore him to compare these different options, see what might make sense for his timeline, and really just play around and see what might get you the most money for what you’re going to be saving up, which in Henry’s case is going to be thousands of dollars. So you’ll probably get a pretty decent return on any of these options. But one thing that does unify all of them is that they’re pretty easy to set up. You can do them for free, and we also have a podcast episode about which accounts can make you the most money. So if you really want to learn more about that, check out that episode.
Liz: And there’ll be a link in the show notes to get you to that podcast.
Sean: All right, Henry, that’s all we got. I hope this helps you make the most of your years living at home and build up a really good down payment. Before we say bye, Holden, do you have any final words of wisdom?
Holden: The best mortgage rates go to people with credit scores of 740 or higher. So, work on that credit record. Pay those bills on time, get that credit score as high as possible. And then when you’re ready to actually buy a home, talk to a mortgage lender before you start actually talking to realtors and looking at houses because when you talk to a lender, he’ll be able to tell you how much you’re going to be able to borrow.
Liz: Thanks, Holden. OK, now it’s time for our takeaway tips. Take away tip number one, set your goal. You need to figure out how much money you’re saving and how long you have to save it. We’ve got a great calculator to help you figure out how much house you can buy and what kind of down payment you’re going to put down.
Sean: And next step, if living at home is what you need to do to meet your financial goal, whether it’s paying off debt or saving up for a house, don’t let any shame or social stigma get in a way of that because your friends are probably just jealous, honestly.
Liz: Final tip, shop around for the best accounts. If you park your money in your local brick and mortar bank, you’re going to be earning some interest, but it’s a fraction of what you could earn if you put the money in an online savings account that had a high yield, in a certificate of deposit or some of the other options that are out there.
Sean: And that is all we have for this episode. Do you have a money question of your own? Turn to the nerds and call us or text us on the nerd hotline at (901) 730-6373. That’s (901) 730-NERD. You can also email us firstname.lastname@example.org, and you can even email us your voice memos. Also, visit nerdwallet.com/podcast for more info on this episode, and remember to subscribe, rate and review us wherever you’re getting this podcast.
Liz: And here’s our brief disclaimer, thoughtfully crafted by NerdWallet’s legal team. Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This nerdy info is provided for general educational entertainment purposes and may not apply to your specific circumstances.
Sean: With that said, until next time, turn to the nerds.