How to save for a home: Part 3
Getting prequalified, and saving for a down-payment
Welcome to the premium edition of Graham’s newsletter! These courses are just one of the perks you will get as part of being a paid subscriber.
Let me know what you think about the course in the comments below, and what other topics you would like me to cover.
This is a longer article than usual. Click here to read it on Substack and bookmark it.
Now you understand the pros and cons of buying a house versus renting, the details of a mortgage, and the different options available to you out there. It’s time to get down to strategy. In part 3 of this course, we will be looking at the run-up to the actual purchase: How do you save up the down payment, what do you need to do to get the best deal with lenders, and what mindset do you need to set yourself up to have the upper hand in hunting for a house?
To understand the way to approach this, let’s take a look at how people make decisions. While making any decision, there are mainly two factors that govern your decision – The potential of reward and the fear of loss. But as you might already know, people are much more sensitive to the pain of loss than the prospect of gaining something. There are good reasons for this. In the short term, it helps with survival. But when you take a decision with long-term prospects in mind, being driven by fear of loss can make you panic and commit to something that doesn’t exactly fit your requirements. Buying a house is a 7 to 10-year commitment at the very least: So how do you avoid this pitfall?
It comes down to one concept: Optionality.
Gaining the high ground
In part one of the course, we briefly discussed the route to wealth creation: Spending less than you earn and investing the difference. That’s a good blueprint for how to go about it, but it doesn’t explore why wealth creation is worthwhile. What’s the point in sacrificing present enjoyment for future growth when you’re just deferring what you could be enjoying right now? One way to look at it is that wealth gives you freedom, but a better definition is what Nassim Taleb calls building optionality.
Creating wealth is about putting yourself in a position where you have the choice to decide between multiple options but not the obligation. Though that sounds simple, this concept has wide-ranging implications:
Being self-employed and creating a business could be a riskier option than having a job – but getting progressively better at it might give you access to more opportunities and more control over how you spend your time.
Investing in your own education and acquiring skills might be a trade-off in terms of time and money, but it might give you a number of potential jobs to choose from that are better suited to your interests, and the power to reject work that you don’t like.
If you are a buyer or seller in a marketplace, if you have many options to choose from, you can walk away from any deal you don’t like. But if your number of options is less, you might feel compelled to seize the first deal you get and be pressured into accepting it regardless of the terms.
The marketplace scenario is applicable to real estate – If you can set yourself up to have the most number of options that suit you, you will have the upper hand in any deal and it could be more likely that you will find a home that fits all your needs. Luckily, it’s not rocket science – there’s a systematic way to maximize your options in this case. We will be focusing on three strategies for these three factors:
Sorting out your credit situation
Getting pre-qualified by lenders
Saving for a down payment
Demolishing debt
Juggling multiple loans while going for the purchase of your first home could stress you out, and you might also leak money because of not consolidating all the debts. My first suggestion to manage your credit effectively is to pay off all high-interest debt before you start. This includes:
Any credit card debt – The average credit card debt in the US was $5,910 in 2022. Those few thousand dollars might cost you a lot in extra interest and loan eligibility.
Personal loans – For people with good credit, this can seem like an easy way to access money. But the interest rates that are charged on these loans are exorbitant, ranging from 18 to 25%. While you “save” for a down payment, you are actually bleeding money on these other debts.
Student loans – I’m a bit split on this one. Student loans can be difficult to pay down before you start saving for a house. My rule of thumb would be, if the interest rate is 4.5% or below, you could consider paying it out over a longer period of time, but if it’s higher than that, it might restrict your ability to get a good loan. So paying it off or refinancing it might be worth looking into.
When you have multiple types of high-debt loans, paying them off might be overwhelming. There are two systematic ways to approach this, and what suits you would be based on the timespan and priorities you have in mind. They are:
The Avalanche Method:
This method’s aim is simple – to save you money on interest payments. You just arrange all your debts in the order of their interest rates, and pay the minimum on all of them except the one with the highest rate. By attacking the high-rate debt first, you could close it out faster, and the interest you save there would go into the next highest debt, and so on. If you have multiple debts which you plan to pay over a longer period of time, this could make sense.The Snowball Method:
This one has been popularized by Dave Ramsey as the go-to method for most people, not because it is financially optimized but because it has a psychological benefit that snowballs with time. The method is simple: Arrange your debts in the order of their magnitude (NOT interest rate), and pay the minimum on all debts except the smallest debt. When you close out the smallest debt, you get a psychological boost that keeps you motivated to attack the other debts harder and close them out.
Now when does it make sense to use one method over the other? If you have a head for numbers, you can work out the benefit of using one over the other, and in most cases, the avalanche method will come out on top financially because the interest payments decrease with time. But the catch is that it might take a long time to see progress with this method because your outstanding debt might be reducing in value without getting closed. If you need help staying motivated and want to see visible progress, the snowball method might cost a little more money but could help you stay on track. You can decide according to your temperament.
Another strategy to pay off debts is Debt Consolidation. With this method, you would be rolling up all your high-interest debt into a single loan with a lower rate, and you could then pay off this loan (but don’t get carried away and borrow more on the consolidated loan. That defeats the purpose).
One way to do this is with a Balance Transfer credit card. For a fixed fee, you would be able to transfer your loans to a card with 0% APR for 6 months to 2 years. But make sure to pay off the loan in this period, because after the initial period, you could be paying upward of 18% interest on the card!
If you have good personal credit, you can also consider a debt consolidation loan, which buckets all your high debt into a single loan with a possibly lower interest.
Closing off high-interest debt is the first step to getting your credit score in shape – but if you are someone who has no history of credit (like I was when I started), if you are just beginning your career, or have a bad credit score and are trying to turn it around, getting your credit score in shape is a topic in itself – I might cover it in a future course, so stay tuned!
Now let’s move on to why you should get pre-qualified and what lenders look for…