I want a home some day. How should I prepare?

What are the benefits of owning your home?

Even if you don’t buy a home, you still need to pay something for lodging. For most people, this is in the form of monthly rent. When you buy a home and pay a mortgage, you’re actually saving into a permanent asset. Plus, you get automatic protection against rising rent costs. See how to value a home as an asset

Owning your home comes with a few potentially significant tax breaks. While you don’t get a tax deduction for paying rent, as a homeowner you can deduct the interest you pay on up to $750,000 of your mortgage balance and up to $40,000 in property taxes. When it comes time to sell your home, you can exclude capital gains up to $250,000 (or up to $500,000 if you file a joint tax return with your spouse).

The most significant benefits to owning your home are likely not financial. You want to buy a home because you want a place to call your own, a place that gives you freedom to live the life you want. Your reasons are often justifiably emotional, which is why the case for buying a home can’t simply be rationalized by a financial model.

How does a home fit in with my other goals?

The right home is one that still allows you to meet your other financial priorities with confidence. This means understanding how much home you can afford, and also having a clear sense of your other goals — both short and long term.

1. Before you start saving for a home, consider putting money towards paying down high interest loans. There are differing opinions about what constitutes a “high interest loan,” but as a rule of thumb, you might want to consider paying down loans with interest rates greater than 8%, such as credit card debt.
2. Next, consider contributing to your company-sponsored 401(k) if your employer offers a matching contribution. An employer match is basically free money, making it much more attractive to participate.

After you pay down debt and put money towards your 401(k), it's time to understand what your financial priorities are. Do you want to cover your children's college education costs in full? What about having a comfortable lifestyle in retirement? Do you need to buy a home sooner than later? Once you've decided the relative importance and timing of these priorities, you can then determine how much of your savings to allot to each goal.

The reality is you only have so much money to work with, so prioritizing one goal will have an impact on the others. To illustrate how to consider tradeoffs, let’s walk through a very simplified example. Let’s say you’re deciding between buying a larger home that costs $800,000 or a more modest home that costs $500,000.

What can I do today to be prepared?

If a home purchase isn't in your immediate future, there are a few things you can do to better prepare far in advance.

1. Pay down any debt

   When you pay down your debt, you decrease your debt-to-income ratio. This is a key input in determining the terms and interest rate for your mortgage. As a rule of thumb, we suggest keeping your debt-to-income (DTI) ratio below 43%. See more details about mortgages.

2. Improve your credit score

   Lenders use your credit score to assess the risk they take on when giving you a loan. They use it to determine whether you qualify for a mortgage and what interest rate you’ll pay. A healthy credit score is 740 or higher and you’ll get the best interest rates with a 780 or above. To increase your score, monitor it via credit reports, set up bill payment reminders and pay down any debt. Source: “How to repair my credit and improve my FICO scores” by My FICO.

3. Save intentionally

   This might seem like a no-brainer, but everyday expenses can get in the way of proactively saving for larger goals. By defining a monthly amount to put towards a home and depositing it in an appropriate savings or investment account, your future won’t become an afterthought. Learn more about how to invest home savings.

Time can be your friend. A longer time horizon means more time to save for your down payment and build up your credit score. However, just because you’re buying more time to save for a home purchase doesn’t mean you don’t have living expenses. Be sure to factor in rent and other household expenses into your savings plan.

How should I invest my home savings?

There are several ways to invest in the funds you've set aside for a future home purchase. The right option for you, depends on your time horizon.

Markets can be volatile from year to year. In fact, our analysis shows that there could be a 25.2% probability of loss for investments held for just one year. For near-term home purchases, it’s more prudent to stay out of the markets to avoid a potential downturn. If your home purchase is in the next five years, consider investing funds for a down payment in a lower-risk option, such as a high-yield savings or cash account (like the Wealthfront Cash Account), fixed income (like Wealthfront’s Automated Bond Ladder or Automated Bond Portfolio), certificates of deposit (CDs), or a money market account.

If your time horizon is longer, your savings can afford to take on more risk. For home purchases that are more than five years away, consider investing your money in a long-term diversified investment portfolio, which can deliver higher returns than short-term savings options. As you get closer to purchasing a home, we suggest moving that money from your investment account to a safer, low-risk option, as mentioned above. Consider investing your long-term savings with Wealthfront.

What's next?

If a home is further in the future, time is on your side. Start early by getting your finances in shape and saving intentionally for that purchase.