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As you collect your spending data, think about how your proposed home purchase will affect and change your spending habits and ability to save. For example, as a homeowner, if you live farther away from your job than you did when you rented, how much will your transportation expenses increase? If you currently don’t live in a common interest development (that is, a community with a homeowners association), you’ll quickly learn about dues and sometimes special assessments, which are rarely anticipated and included in your budget.

Table 1-2 can help you total all your current expenses and estimate future expected spending.

TABLE 1-2 Your Spending, Now and After Your Home Purchase

Acting upon your spending analysis

Tabulating your spending is only half the battle on the path to fiscal fitness and a financially successful home purchase. After all, many government entities know where they spend our tax dollars, but they still run up massive levels of debt! You must do something with the personal spending information you collect.

When most Americans examine their spending, especially if it’s the first time, they may be surprised and dismayed at the amount of their overall spending and how little they’re saving. How much is enough to save? The answer depends on your goals and how good your investing skills are. For most people to reach their financial goals, they must annually save at least 10 percent of their gross (pretax) income.

From Eric’s experience as a personal financial counselor and lecturer, he knows that most people don’t know how much they’re currently saving, and even more people don’t know how much they should be saving. You should know these amounts before you buy your first home or trade up to a more costly property.

If you’re like most people planning to buy a first home, you need to reduce your spending to accumulate enough money to pay for the down payment and closing costs and create enough slack in your budget to afford the extra costs of homeownership. Trade-up buyers may have some of the same issues as well. Where you decide to make cuts in your budget is a matter of personal preference. Here are some proven ways to cut your spending now and in the future:

❯❯ Purge consumer debt. Debt on credit cards, vehicle loans, and the like is detrimental to your long-term financial health. Borrowing through consumer loans encourages you to live beyond your means, and the interest rates on consumer debt are high and not tax deductible. If you have accessible savings to pay down your consumer debts, do so as long as you have access to sufficient emergency money from family or other avenues.

❯❯ Trim nonessential spending. Although everyone needs food, shelter, clothing, and healthcare, most Americans spend a great deal of additional money on luxuries and nonessentials. Even some of what people spend on the “necessity” categories is partly for luxury.

❯❯ Purchase products and services that offer value. High quality doesn’t have to cost more. In fact, higher priced products and services are sometimes inferior to lower cost alternatives. With so many products available online these days, and local bricks-and-mortar stores willing to price match, a little research can go a long way to finding real savings.

❯❯ Buy in bulk. Most items are cheaper per unit when you buy them in larger sizes or volumes. Superstores such as Costco, BJ’s Wholesale Club, Sam’s Club, Target, and Walmart offer family sizes and competitive pricing.

Establishing financial goals

Most people find it enlightening to see how much they need to save to accomplish particular goals. For example, wanting to retire while you still have good health is a common goal. And the good news is that you can take advantage of tax incentives while you save toward retirement.

Money that you contribute to an employer-based retirement plan – for example, a 401(k) – or to a self-employed plan – for example, a SEP-IRA – is typically tax deductible at both the federal and state levels. Also, after you contribute money into a retirement account, the gains on that money compound over time without taxation.

If you’re accumulating down-payment money for the purchase of a home, putting that money into a retirement account is generally a bad idea. When you withdraw money prematurely from a retirement account, you owe not only current income taxes but also hefty penalties – 10 percent of the amount withdrawn for the IRS plus whatever penalty your state collects.

If you’re trying to save for a real estate purchase and save toward retirement and reduce your taxes, you have a dilemma – assuming that, like most people, you have limited funds with which to work. The dilemma is that you can save outside of retirement accounts and have access to your down-payment money but pay much more in taxes. Or you can fund your retirement accounts and gain tax benefits, but lack access to the money for your home purchase.

You have two ways to skirt this dilemma:

❯❯ Borrow against your employer’s retirement plan. Some employers’ retirement plans, especially those in larger companies, allow borrowing against retirement savings plan balances. Some companies offer first-time homebuyers a little financial assistance, so make sure you ask. Because you are borrowing your own money, the monthly payment (including interest) all goes back to your account. Also, monthly payments back to your retirement account do not count against your debt ratios.

❯❯ Implement a first-time home-buyer IRA withdrawal. If you have an Individual Retirement Account (either a standard IRA or a newer Roth IRA), you’re allowed to withdraw up to $10,000 (lifetime maximum) per individual IRA account (so a married couple can access $20,000) toward a home purchase as long as you haven’t owned a home for the past two years. Tapping into a Roth IRA is a better deal because the withdrawal is free from income tax as long as the Roth account is at least five years old. Although a standard IRA has no such time restriction, withdrawals are taxed as income, so you’ll net only the after-tax amount of the withdrawal toward your down payment.

Because most people have limited discretionary dollars, you must decide what your priorities are. Saving for retirement and reducing your taxes are important goals; but when you’re trying to save to purchase a home, some or most of your savings needs to be outside a tax-sheltered retirement account. Putting your retirement savings on the back burner for a short time to build up your down-payment cushion is fine. However, be sure to purchase a home that offers enough slack in your budget to fund your retirement accounts after the purchase.

Making down-payment decisions

Most people borrow money for a simple reason: They want to buy something they can’t afford to pay for in a lump sum. How many 18-year-olds and their parents have the extra cash to pay for the full cost of a college education? Or prospective homebuyers to pay for the full purchase price of a home? So people borrow.

When used properly, debt can help you accomplish your financial goals and make you more money in the long run. But if your financial situation allows you to make a larger than necessary down payment, consider how much debt you need or want. With most lenders, as we discuss in Chapter 5, you’ll get access to the best rates on mortgage loans by making a down payment of at least 20 percent. Whether or not making a larger down payment makes sense for you depends on a number of factors, such as your other options and goals.

The potential rate of return that you expect or hope to earn on investments is a critical factor when you decide whether to make a larger down payment or make other investments. Psychologically, however, some people feel uncomfortable making a larger down payment because it diminishes their savings and investments.

You probably don’t want to make a larger down payment if it depletes your emergency financial cushion. But don’t be tripped up by the misconception that somehow you’ll be harmed more by a real estate market crash if you pay down your mortgage. Your home is worth what it’s worth – its value has nothing to do with the size of your mortgage.

Financially, what matters in deciding to make a larger down payment is the rate of interest you’re paying on your mortgage versus the rate of return your investments are generating. Suppose that you get a fixed-rate mortgage at 6 percent. To come out financially ahead making investments instead of making a larger down payment, your investments need to produce an average annual rate of return, before taxes, of about 6 percent.

Although it’s true that mortgage interest is usually tax deductible, don’t forget that you must also pay taxes on investments held outside of retirement accounts. You could purchase tax-free investments, such as municipal bonds, but over the long haul, you probably won’t be able to earn a high enough rate of return on such bonds versus the cost of the mortgage. Other types of fixed-income investments, such as bank savings accounts, CDs, and other bonds, are also highly unlikely to pay a high enough return.

To have a reasonable chance of earning more on your investments than it’s costing you to borrow on a mortgage, you must be willing to invest in more growth-oriented, volatile investments such as stocks and rental/investment real estate. Over the past two centuries, stocks and real estate have produced annual average rates of return of about 9 percent. On the other hand, there are no guarantees that you’ll earn these returns in the future. Growth-type investments can easily drop 20 percent or more in value over short time periods (such as one to three years).