Coming Up With the Cash (Gulp!) for a Down Payment

Dear Reader,

The purchase of your first home is a fairly momentous occasion: You're putting down roots and making a real commitment to a community. But the financial commitment is even bigger. For most people, buying a home is the largest single investment they'll ever make. It's a good idea to proceed prudently, and you're right to be thoughtful about how to finance the down payment. It's a huge amount of money to fork over, and you don't want to endanger your overall financial health.

Without knowing more details about your personal situation, I have a couple of points to make—and I also want to underscore the benefits of making a bigger down payment if you can. Just so we're on the same wavelength, I'm assuming you have more than enough cash and securities to make the down payment, and you're asking which assets to tap first.

Liquidity is a very good thing

First, it's never a good idea to use up all your liquid assets, even if you have a good job and a steady, reliable income. Everyone needs an emergency reserve, a financial cushion that could cover living expenses for at least three and preferably up to six months. Should you be laid off or have an accident that prevents you from working for awhile, or a family situation requires cash immediately—that emergency fund, safely stowed in your checking or money market account, will be indispensable. Some people consider stock market assets as an emergency fund, but do you really want to be forced to sell if the market is heading down?

So as you plan your home purchase, make sure you keep some liquidity to prepare for the unexpected. It's worth noting here that most home buyers do run into unexpected expenses. (My bathroom pipes broke the week I moved into my last house!) And, don’t forget all the expenses connected to moving into a new home—including costs to "spruce the place up" (new drapes, carpeting, landscaping, etc.). As you plan your home purchase, first subtract your emergency fund and any anticipated relocation and moving-in costs from your liquid assets. If you still have enough for the down payment, you're in great shape. If not, you'll have to sell some investments. How do you choose?

Time to rebalance?

You might start that decision-making process by taking a look at your total investment portfolio with an eye towards rebalancing, an exercise that might identify some candidates to sell. Rebalancing simply refers to the idea of buying or selling assets to get your portfolio back to the appropriate target asset allocation (or the mix of stocks, bonds, and cash that reflects your long-term goals and your risk tolerance). A detailed discussion of asset allocation is beyond the scope of this article, but I've addressed the topic in past columns and Schwab.com/marketinsight has a lot more information.

In a nutshell, when you rebalance, you're selling your best-performing assets and buying more of those assets that are out of favor. For example, if you currently have lots of exposure to stocks (entirely appropriate, by the way, for someone your age), a rise in equity values may have over weighted the equity portion of your portfolio. Say your target asset allocation is 80% stocks, 15% bonds, and 5% cash. As an example, let's say that since you set up the portfolio, the stock portion increased in value while the bond portion stayed the same. Now you've got 85% of your portfolio in equities, and only 10% in bonds. In order to get back to your target allocation, you might ordinarily sell some stocks and buy some bonds. But since you're shopping for a house, you could instead sell some stocks and use the proceeds to fund your down payment.

And regardless of why you sell your assets, or which assets you sell, make sure you periodically rebalance your portfolio so that the asset allocation is still a good fit for your time horizon and risk tolerance.

Consider the impact of taxes when you sell stocks

The other way I'd approach the question of what to sell is by starting with the most tax-efficient gains possible: stocks with long-term capital gains (long-term for tax purposes means you've held the asset for more than one year). Federal tax treats long-term gains differently from short-term gains, which are taxed at normal income rates. The break can be substantial, depending on your tax bracket, and your tax advisor can help you. You might even be able to sell some stocks at a loss to offset the gains to reduce your tax liability still further. Don't forget to factor in your tax consequences as you plan out the stock sales: You could owe Uncle Sam and your state government a hefty sum if you sell a lot of stock to buy your new home.

If you own stock or stock options in your company, consider selling some of that asset. Many people have too much invested in their own company stock: They're already heavily "exposed" to the risks of that company by working there (if the company tanks, you could lose your livelihood as well as your investment). So if you've purchased or been given stock or options, that might be a good source of funds for your down payment (and a good way to reduce your exposure to your own company). As you may know, many companies have restrictions on selling stock or options, so you'll need to check with your benefits department to see if this is a viable avenue for you. Also, those sales can take a little time, so if you're counting on those funds for your down payment, start now to make sure you'll have the funds in hand when you need them.

I might add here that it's usually a terrible idea to divest your IRA or 401(k) assets to make a down payment. The IRS does permit you to withdraw IRA funds up $10,000 for a down payment on your first home without the normal 10% penalty, but you'll still have to pay the income taxes on that withdrawal. And, of course, that's $10,000 you won't have for retirement either. Some 401(k) plans allow you to borrow against your balance, but of course you're reducing your retirement funds and you have to pay back the loan plus interest with after-tax dollars. If you have a Roth IRA, you can use the funds, penalty- and tax-free, for your down payment (subject to certain rules; check with your tax advisor), but that means you'll have that much less to withdraw tax-free down the road when you retire. In general, you don't want to raid your retirement plan to finance your new home.

Pay at least 20% if you can

For many people, especially younger workers, the down payment represents a pretty formidable hurdle to the goal of home ownership—so much so that some people are paying 10% down or even less and financing the rest (in some instances during the housing boom, buyers were financing 100% of their mortgage!). But this can add substantially to the cost of your new home, so if it's at all possible, put 20% (or even more) down

Also keep in mind that if you put just 10% down, you'll almost certainly pay a higher interest rate than someone putting down 20%, and you'll likely be asked to buy private mortgage insurance (PMI). PMI will be part of the package provided by your mortgage provider, but make sure you know how much it's going to cost you (it can easily amount to a few hundred bucks a month) and when you can stop it. When you have sufficient equity in the home, you no longer have to have the PMI (under Federal law, PMI isn't required and ends automatically when the mortgage is paid down to 78% of the original value of the house).

Buying your first home is never easy, given the substantial upfront costs, the anxiety about the commitment, and the risks of home ownership (true, housing prices have soared in recent years in many parts of the country, but prices go down as well as up). By being prudent about the down payment, you can take some of the worry out of the process, which should help you enjoy the primary benefit of buying a house: the chance to build a home.

Good luck!

(0107-4595)