How Much Can You Afford?

Getting the Down Payment Together

Traditionally, the standard down payment was 20%, but this can vary based on several factors. When you also figure in the fact that housing prices have increased over the last decade in most parts of the country, you realize that affording the monthly mortgage payment isn't necessarily what keeps folks from owning their own homes. It's coming up with the money for the down payment. So, once you decide you're ready to take the big step, you need to realistically assess your resources and determine what you can afford.

SUGGESTION: If you are a first-time homebuyer, you may qualify for special government-backed mortgages that will accept a lower down payment.

Examine Your Resources Carefully

Source 1: Your Own Savings

Presumably, you've been putting money aside in a separate fund to buy real estate. Today's down payment requirements make it difficult to purchase real estate unless you've got a considerable stash put away. First-time home buyers spend an average of 2½ years saving for their down payment. If you don't feel comfortable with the amount you've managed to put away, we will give you ideas on how to boost your savings rate.

Source 2: Your Other Assets

Too often, we think of available cash as just that: money we have managed to save in savings accounts, money market funds, and certificate of deposit (CDs). We lose sight of other assets which we own when, if sold, may lead to significant additional sources of money. You may have a considerable amount of savings bonds that your grandparents gave you each holiday. Or, what about that stock that was given to you when you were a child? Do you participate in a company stock purchase program? Don't think of just cash; think of items that you can convert to cash as well.

Source 3: Gifts from Parents and Relatives

If you're fortunate enough to have family members who want to give you money, you can certainly use it to pay for the property. Anyone can give up to $14,000 per year, or $28,000 per year if it is a joint gift, to as many people as they wish, without having to pay federal gift taxes. So, each parent (or grandparent) can give you $14,000. If you're married, your in-laws could do the same, if they have the money. If both spouses have two living parents, that could be a total of $56,000. The person receiving the gift is not required to pay income taxes on any amount received.

Source 4: Family Loans

If a parent or relative is not willing to give you the money you need, perhaps they would consider lending you the money instead. The important thing to remember here is that they should charge you a reasonable interest rate, reasonable meaning that it is based on current market rates. The IRS sets a minimum interest rate, called the Applicable Federal Rate (AFR), which is subject to change monthly. Make sure that you have a written, enforceable note (i.e., a legal document) that clearly spells out the terms of the loan. Without this note, the IRS may decide that your loan is really a gift and impose gift taxes on the loan. If the loan is deemed to be a below-market loan, the IRS may impute interest on the loan. Consult your tax professional for more information.

IMPORTANT NOTE: Many lenders will not allow you to use borrowed money for a down payment. You should check with the lender for their requirements.

SUGGESTION: Make sure that the terms of the note stipulate that it is collateralized (secured) by the property. In that way, the interest on the loan would be deductible for federal income tax purposes.

SUGGESTION: If you have outstanding personal loans, it is to your advantage to finance as much of the price of the home as possible. By reserving as much of your cash as possible, you'll be able to pay off your personal debt. By doing so, you will convert non-deductible interest on the personal loan to potentially tax-deductible interest on the mortgage loan, and save some tax dollars.

Adopt this philosophy: If your money is growing at a higher after-tax rate than the after-tax rate at which a lender will loan you the money, borrow the money and leave those investments alone.

Source 5: Equity Sharing

Through this arrangement, a third party, frequently parents, lends you the money for the down payment and in return receives a piece of appreciation in the property, plus in some cases, may receive interest income from you. For example, they may receive 5% interest and a 50% stake in the appreciation on the home in return for lending you $20,000. As an alternative, the "investor" provides the down payment and you, the "occupant-owner," pay the closing costs, monthly mortgage, and upkeep. Eventually, the owner-occupant can buy the investor's interest in the property, or they can sell the property and share the appreciation in value.

Source 6: Renting with a Buy Option

This gives you the right to buy a home you are renting within a specified time period, say one to three years, at a negotiated price. Part of your monthly rent payment goes toward building up the down payment. Most rent-with-the-option-to-buy plans charge the renter a fee that could range from $1,000 to $5,000.

Source 7: Private Mortgage Insurance (PMI)

A lender may grant a mortgage if you have a small down payment, but you will be subject to PMI. Private Mortgage Insurance is sold through banks and mortgage companies to cover the difference between a lower down payment and the 20% usually required by most lenders. It insures that, should you not be able to make your mortgage payments and your home is foreclosed, the PMI company will make good on a pre-determined percentage of the outstanding balance, thereby reducing the lender's loss. While this is not a source of funds, it could lower the amount the lender will require from you for your down payment.

If you are subject to PMI, you may be able to reduce your initial down payment below 20%. Most lenders carry policies with several companies. Needless to say, this flexibility comes at a price. Most policies will require an up-front payment of as much as 1% of the amount you're financing plus an additional monthly fee, which is automatically added to your mortgage payment. Although this option can be expensive, many times it means the difference between being able to afford your first home and postponing the purchase until you can save additional money for the down payment.

Source 8: Life Insurance Loan

If you have a cash-value life insurance policy, you can borrow against the cash value, often at reasonable interest rates. When you do, however, your death benefit is reduced by the amount you borrow. That means that if you die while the loan remains outstanding, your heirs will receive less than the policy's face amount.

IMPORTANT NOTE: Although you can basically set your own repayment schedule on a life insurance loan, if you don't repay the loan and enough interest expense accumulates, you could lose your insurance coverage and possibly be forced to pay taxes on part of what you borrowed.

Source 9: Retirement Plans

You may be able to borrow against a defined contribution retirement plan, such as a 401(k) or company profit-sharing plan. The general rule is you can only borrow up to half of your vested balance or $50,000, whichever is less. In some plans, if 50% of the vested balance is less than $10,000, the employee can still take out up to a maximum of $10,000. You must repay the loan within five years, although loans used to purchase or substantially improve your home can have a longer payback period. The interest expense is not tax-deductible. Employers may impose other limits on this type of loan.

There are also certain situations where you can take a hardship withdrawal to use the money in an emergency, but there are income tax disadvantages when you withdraw your money from the plan. You should generally use this as the last resort.

IMPORTANT NOTE: We recommend that you do not take a hardship withdrawal and find other ways to obtain the money you need.

Qualified first-time homebuyers can take a penalty-free distribution from an IRA, subject to a $10,000 lifetime limit.

Source 10: Loan Guarantee Programs

If you are eligible, the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), and the Rural Development division of the Department of Agriculture all have loan programs that require little or no down payment to qualified buyers. Also, most states have subsidy programs in place for first-time home buyers. Check what's available by calling your state's housing agency.

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