Many young homeowners foresee moving to a bigger home when they start a family. And a relocation for work or school could also dictate house sales and purchases. This blog uses a hypothetical example to answer the question: how should I save for my next house?
How Much Do You Need to Save?
Define the goal. When do you reasonably expect to move? The more specific you can be, the better. If moving is a nice idea but you don’t see it happening in the next few years, your idea may be more of a desire than a goal. In our example, we’ll assume that moving in 5 years is your goal.
Estimate the next house’s cost. Hot markets are hard to forecast, and so are cold ones. Your realtor can provide you with historical sales data for your desired neighborhood. This won’t be perfect, but it’s a good place to start. Some rules never change: good school districts, newer construction, basements, and fourth bedrooms all add value and flexibility. These should add positively to your estimate of future cost. In our hypothetical example, we’ll assume that the target house costs $500,000.
Calculate your current net equity. In our example, we’ll assume that you would plan to list your current house at $300,000 and that the mortgage balance is $240,000. This means that equity in your home is $60,000, or 25%, correct? Not exactly. Everyone has heard stories of offers coming in above the list price on the first day. You’ve also heard about – or owned – houses that don’t sell for many months.
One way of understanding which situation you’re in is to look at the trend in average time from list to closing. An easy rule of thumb is that houses listed by realtors (as opposed to for sale by owner listings) should sell for roughly 96-98% of their list price. Realtors know how to price houses. In this case, let’s say that the current house sells for $290,000. Don’t forget commission costs. Historically, commission rates have occupied a fairly wide range between 4% and 7%, with most falling in the 5-6% range. You may be able to find flat rates for listing, but beware that you don’t give up too many incentives for a capable agent. Typically – but not always – the selling party pays the commission. In this example, we’ll assume a commission rate of 6%, leaving a net sale price to you of $272,600 ($290,000 – 6%).
The current net equity is $32,600 ($272,600 – $240,000) – a far cry from $60,000. That sounds bleak, but the good news is that your current mortgage is already working for you – if you have a conventional, amortizing mortgage. Remember that each month a portion of your payment goes to principle repayment. On a conventional 30-year mortgage, the amount going to principle gradually increases each month. Your mortgage company can provide you with an amortization schedule showing principle balance after five years of regular payments. Let’s say you determine that after 5 years, you will have paid down $15,000 of principle. This will increase your net equity to $47,600 ($32,600 + $15,000).
Determine your required saving goal. If the new house will cost $500,000, your mortgage company will likely require a 20% down payment to avoid the costly additional premium for private mortgage insurance (“PMI”). In this case, 20% of $500,000 is $100,000, or $52,400 above your current projected net equity. Is it realistic for you to achieve that over the next 5 years – can you expect to save $873 per month? If yes, then your goal is reasonable. Just make sure you stick to that saving plan.
Where to Save
Should you save the $873 / month: a) in a bank savings account, b) by investing it in stocks or bonds, or c) by paying down your current mortgage? Bank savings accounts are safe, liquid saving vehicles. One downside is that they typically don’t pay much interest. Another is whether you think you can resist the urge to spend it on something other than your new house goal.
Investing money in stocks / stock funds when it has been allocated to a goal over a specific short-intermediate time frame is a bad idea. As we mentioned in Payoff the Mortgage Early or Enjoy Life?, stocks perform well over time, but can also be very volatile in the short run.
In this example we favor paying down the mortgage, if you’re serious about your five year goal. In the first place, you’ll effectively earn a return equal to the annual interest rate on the mortgage. This could be 5% or more in the current environment. Secondly, while you could access that equity if needed, it’s much more difficult to do than tapping a savings account – a helpful roadblock if you’re worried about spending it. Finally, paying down a mortgage balance may show evidence of increasing credit worthiness, which may come in handy at your next approval process.
Planning for any goal involves uncertainty. In the case of a goal to buy your next home, the uncertainties are many and varied. Following the process above will help ensure that your plans are based on good information, and remain reasonable.