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We are looking to buy our first home, and are evaluating how much of our savings to put towards the down payment of the property (or how much home to buy in general). When one has a choice, are there any rules of thumb regarding how much existing savings to spend on a home, vs investing?

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    What country are you in? Makes a difference because tax laws differ. – A E Mar 2 '15 at 17:58
  • @AE I am in the US, Charlotte, NC to be exact. – Suan Mar 8 '15 at 0:13
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Rules of thumb? Sure -

Put down 20% to pay no PMI.

The mortgage payment (including property tax) should be no more than 28% of your gross monthly income.

These two rules will certainly put a cap on the home price. If you have more than the 20% to put down on the house you like, stop right here. Don't put more down and don't buy a bigger house. Set that money aside for long term investing (i.e. retirement savings) or your emergency fund. You can always make extra payments and shorten the length of the mortgage, you just can't easily get it back.

In my opinion, one is better off getting a home that's too small and paying the transaction costs to upsize 5-10 years later than to buy too big, and pay all the costs associated with the home for the time you are living there. The mortgage, property tax, maintenance, etc. The too-big house can really take it toll on your wallet.

  • Also, should you need the money for other things, while it is possible t borrow against the house it's a lot faster and easier to access investments in more liquid form. Note to that at current mortgage rates, it isn't hard for returns on investment to exceed what you're paying in interest (even after tax arguments)... one of the safest leveraged investments you can make. – keshlam Mar 1 '15 at 20:12
  • In Australia (and maybe other countries) if you do make extra payments into your mortgage, in many cases you can easily re-draw on those extra payments. Even better with most lenders you can set up a savings account as a linked offset account and any extra funds deposited into the savings account will reduce your interest payable on the mortgage as if the funds were directly deposited into the mortgage, and it is very easy to withdrawal when you need the funds. Makes parking your money into your mortgage very convenient and accessible. – Victor Mar 1 '15 at 20:54
  • A great answer that hits the high points perfectly. I'm sure there have been entire books written on this subject, of course, but this covers the immediate things you need to know. – ChrisInEdmonton Mar 1 '15 at 22:23
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    What is PMI and is this answer specific to any particular place? – gerrit Mar 2 '15 at 4:52
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    @JoeTaxpayer: well, you did assert "If you have more than the 20% to put down on the house you like, stop right here. Don't put more down". Apologies if I've misunderstood this and my paraphrase is wrong. I realise this is all rule of thumb, so I don't mean to imply you're saying there are no exceptions, but would you say that exceptions are rare? – Steve Jessop Mar 2 '15 at 11:41
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The short answer is that it depends on the taxation laws in your country.

The long answer is that there are usually tax avoidance mechanisms that you can use which may make it more economically feasible for you to go one way or the other.

Consider the following:

The long term average growth rate of the stock market in Australia is around 7%. The average interest on a mortgage is 4.75%. Assuming you have money left over from a 20% deposit, you have a few options. You could:

1) Put that money into an index fund for the long term, understanding that the market may not move for a decade, or even move downwards; 2) Dump that money straight into the mortgage; 3) Put that money in an offset account

Option 1 will get you (over the course of 30-40 years) around 7% return. If and when that profit is realised it will be taxed at a minimum of half your marginal tax rate (probably around 20%, netting you around 5.25%) Option 2 will effectively earn you 4.75% pa tax free Option 3 will effectively earn you 4.75% pa tax free with the added bonus that the money is ready for you to draw upon on short notice.

Of the three options, until you have a good 3+ months of living expenses covered, I'd go with the offset account every single time.

Once you have a few months worth of living expenses covered, I would the adopt a policy of spreading your risk. In Australia, that would mean extra contributions to my Super (401k in the US) and possibly purchasing an investment property as well (once I had the capital to positively gear it).

Of course, you should find out more about the tax laws in your country and do your own maths.

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Here in the UK, the rule of thumb is to keep a lot of equity in your home if you can.

I assume here that you have a lot of savings you're considering using. If you only have say 10% of the house price you wouldn't actually have a lot of choice in the matter, the mortgage lender will penalise you heavily for low deposits. The practical minimum is 5%, but for most people a 95% mortgage is just silly (albeit not as silly as the 100% or greater mortgages you could get pre-2008), and you should take serious individual advice before considering it. According to Which, the average in the UK for first-time buyers is 20% (not the best source for that data I confess, but a convenient one). Above 20% is not at all unusual.

You'll do an affordability calculation to figure out how much you can borrow, which isn't at all the same as how much you should borrow, but does get you started. Basically you,

  • decide how much a month you can spend on mortgage payments. The calculation will let you put every penny into this if you choose to, but in practice you'll want some discretionary income so don't do that.

  • decide the term of the mortgage. For a young first-time buyer in the UK I think you'd typically take a 25-year term and consider early repayment options rather than committing to a shorter term, but you don't have to. Mortgage lenders will offer shorter terms as long as you can afford the payments.

  • decide how much you're putting into a deposit

  • make subtractions for cost of moving (stamp duty if applicable, fees, removals aka "people to lug your stuff").

  • receive back a number which is the house price you can pay under these constraints (and of course a breakdown of what the mortgage principle would be, and the interest rate you'll pay). This step requires access to lender information, since their rates depend on personal details, deposit percentage, phase of the moon, etc.

Our mortgage advisor did multiple runs of the calculation for us for different scenarios, since we hadn't made up our minds entirely. Since you have not yet decided how much deposit to make, you can use multiple calculations to see the effect of different deposits you might make, up to a limit of your total savings.

Putting up more deposit both increases the amount you can borrow for a given monthly payment (since mortgage rates are lower when the loan is a lower proportion of house value), and of course increases the house price you can afford. So unless you're getting a very high return on your savings, £1 of deposit gets you somewhat more than £1 of house, and the calculation will tell you how much more.

Once you've chosen the house you want, the matter is even simpler: do you prefer to put your savings in the house and borrow less and make lower payments, or prefer to put your savings elsewhere and borrow more and make higher payments but perhaps have some additional income from the savings. Assuming you maintain a contingency fund, a lower mortgage is generally considered a good investment in the UK, but you need to check what's right for you and compare it to other investments you could make.

The issue is complicated by the fact that residential property prices are rising quite quickly in most areas of the UK, and have been for a long time, meaning that highly-leveraged property investment appears to be a really good idea. This leads to the imprudent, but tempting, conclusion that you should buy the biggest house you can possibly afford and watch its value rises. I do not endorse this advice personally, but it's certainly true that in a sharply rising house market it's easier to get away with buying a bigger house than you need, than it is to get away with it in a flat or falling market.

As Stephen says, an offset mortgage is a no-brainer good idea if the rate is the same. Unfortunately in the UK, the rate isn't the same (or anyway, it wasn't a couple of years ago). Offset mortgages are especially good for those who make a lot of savings from income and for any reason don't want to commit all of those savings to a traditional mortgage payment. Good reasons for not wanting to do that include uncertainty about your future income and a desire to have the flexibility to actually spend some of it if you fancy :-)

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