If you’re like me, you’ve come to the conclusion that owning real estate is the ticket to long-term financial freedom.
The only hiccup: I’m a millennial. With student debt. Living in one of the most expensive metro areas in the U.S.
Since conventional financing for an investment property is 20% down, one needs to accumulate a small fortune to have the necessary “skin in the game” to get started.
First, you’re probably questioning why on earth you would take financial advice from a 26-year-old. But contrary to popular opinion, not all of us Gen-Y’ers are blowing money on artisan coffee and avocado toast.
While I have no shame in admitting I wasn’t the best with money at 21, I’ve fallen into some amazing and transformative work experiences that have whipped my financial literacy into shape. I went from interning at a foreign exchange brokerage, to being a bank teller, to working for a mortgage lender, to eventually joining the team at Roofstock. I speak with real estate investors every day to learn more about their goals, and discuss how Roofstock can help them get there.
If you’re committed to the dream of owning investment real estate but skeptical about the prospects of making it a reality, don’t be discouraged! I’m in the same boat as you, as are many others. It boils down to discipline, smart saving tactics and sticking to a game plan.
Let’s say you’d like to purchase a $100,000 investment property (yes—these exist in the Midwest, South and Southeast, and you can buy them on Roofstock). Here are several smart ways to quickly save up for a 20% investment property down payment.
Main takeaways from this article:
- Use a percentage-based budget like the 50/30/20 rule (or a variation that works for you)
- Reverse engineer what it will take to get the property you want
- Stop trusting your will power and automate your budget
- Tips to trim the financial fat
- Don’t let your student loans negatively amortize
- Be strategic with your credit cards
**A couple of things to keep in mind before we dive in:
- Mortgage insurance doesn't cover investment properties, so the bank will require that you come up with a minimum down payment of 20% on a conventional loan
- The more you can put down to reduce the loan-to-value for the bank, the more you can typically qualify for a lower interest rate, thus reducing your monthly mortgage payment and increasing your monthly cash flow
- If you own a home, you can also use a home equity line of credit (heloc) to tap into the equity and/or appreciation you've built to make the down payment for a rental property. This is a big topic in and of itself, which we've covered in a separate article here. A cash-out refinance is another option on your primary residence.
1. Figure Out Your Current Expenses and Use the 50/30/20 Rule to See How Much Money You Can Save Monthly
Saving for an investment property starts with looking at where your money is already going. If you’re not using a budgeting app or tool that tracks your spending, start now (Mint is my favorite). It’s important to know what percentage of your take-home income is currently being spent on rent, student loans, cell phone bill, car payments, food, etc.
Next, the 50/30/20 rule is a great place to start when it comes to looking at how much you can save monthly. Popularized by Senator Elizabeth Warren, this percentage-based budget is widely recognized as a simple and effective method for managing finances. It’s not perfect, but it is a helpful guideline and can keep you on the right track. I like the advice offered by Deena Drewis of Girlboss.com: If the ratio doesn’t quite work for your personal situation, create your own version (the 70/20/10 perhaps?) using the Envelope Method.
Here is an example of how the rule works for someone who takes home $4,500 each month:
- Use 50% of your take-home income for all of your mandatory/fixed expenses. These expenses will vary a little bit for each person but should include your rent, student loan payments, car payments, etc. This means you have $2,250 to spend on all of these. Critics of the 50/30/20 rule fairly point out that it doesn’t take into account the vast range of rent prices nationwide, which is true. Again—use this rule as an elastic guideline depending on your personal situation.
- Use 30% of your take-home income for discretionary spending. In our example above, that would be $1,350 per month ($337.5/week) to spend on things that aren’t mandatory. This includes subscriptions to Spotify/Netflix, dining, gym memberships and bars/entertainment. Again, Mint is great for this. If you’re approaching your 30% threshold for spending, the app can alert you that it’s time to dial back the Amazon shopping.
- Save the last 20% of your take-home income. In this case, that’d be $900 a month. The best way to set this up is through automation, which we’ll talk about more below. Once you’ve set your monthly saving amount, you can begin to forecast how long it will take to save up for a 20% down payment on an investment property.
2. Reverse Engineer What It Will Take to Get the Property You Want
Say you're aiming to purchase an investment property in the ballpark of $100,000, and you want to achieve this in two years. This will require a minimum down payment of $20,000, plus extra for closing costs and a contingency fund. Closing fees typically amount to 1-5% of the purchase price of the home, and it’s wise to keep a rainy day fund of at least 1-2% of the purchase price.
So your saving plan starts with a little basic math. First, calculate a rough estimate of your closing costs and contingency fund. We’ll say closing costs come in at 2% of the purchase price.
Closing costs: $100,000 x .02 = $2,000
Contingency fund: $100,000 x .02 = $2,000
Next, add this to your down payment and divide it by 24 months to calculate how much you need to put away each month over the course of two years.
($20,000 + $4,000)/ 24 months = $1,000
If putting away an extra $1,000 a month sounds ludicrous, consider stretching your timeline to three years or setting your sights on an investment property in the $50,000-$70,000 range. Again, these properties exist on Roofstock! Visit our marketplace and adjust the "list price" filter.
3. Stop Trusting Your Will Power and Automate Your Budget
How many budget spreadsheets have you made in the past, and then abandoned within a few weeks of creating them? The answer: Every. Single. One.
We know we need to save money, but we also need to acknowledge our human nature. And that nature is to spend our cash.
I’ve consumed a respectable share of financial self-help literature, and some of the most sensible advice I’ve seen comes Ramit Sethi, author of “I Will Teach You To Be Rich” (self-admittedly a horrible title).
Sethi’s advice is wrapped around two ideas: (i) automation, and (ii) cutting down on expenses that don’t add a ton of value to your life.
Let’s explore the first part, automation. Sethi points out that we as people are horrible at sticking to budgets, and people who say things like, “cut back on Starbucks or avocado toast,” are living in an alternate reality. You need your caffeine, and avocado toast is delicious.
(*OK, OK, I know this completely contradicts what I said earlier about millennials. But most of us aren’t splurging on these things every day).
So what should you do?
The answer lies in automating the 50/30/20 rule into existence so you’re not spending cash on a whim each day.
- First, set up all of your fixed payments to come out on the same day of the month so you can see what they amount to exactly (if you don’t already know). Ideally this is no more than 50% of your take-home income, but obviously this isn’t realistic for everyone. Adjust the ratio to make it work for you.
- Next, set up an automatic transfer that funnels 20% of your take-home income into an account dedicated to the down payment on your investment property.
- Once you’ve taken care of mandatory expenses and savings, you’re free to spend the rest of your money on as much avocado toast as your heart desires.
The second part of this plan requires you to trim some of the financial fat in your life. This means looking at things that don’t drive a ton of value—for example, subscription services for clothing, magazines, the 900 channel package on Direct TV, etc.
This “trimming” also includes small lifestyle tweaks. When you survive college on homemade frozen stir fry concoctions, salad, and potatoes, and you bike or bus everywhere, it’s tempting to not to use Uber all the time and eat out the second you get paid or have some extra cash. Resist!
A quick search on Google will yields hundreds of creative life hacks to cut down on costs and save money. I challenge you to find at least 5 new ones this month and give them a try.
Common services to consider downgrading from:
- Gym memberships
- Bank fees (you can negotiate these down)
- TV and Internet packages (see if you can find a cheaper subscription to Netflix, Hulu or Sling)
- E-commerce subscriptions (Birchbox, Le Tote, Stitch Fix, Blue Apron, Freshly, Gadget Box, ect.)
Two More Helpful Tips for Saving
1. Don’t let your student loans negatively amortize
You know what makes a student loan even worse? Negative amortization. This occurs when the payments on a loan are less than the interest that accrues, causing the balance owed on the loan to increase.
If you defer repayment on your loan(s), any accrued but unpaid interest is capitalized by adding it to the loan balance, according to the experts at FinAid. The capitalized interest causes the size of the loan to increase, and you could end up owing more than the loan is ultimately worth.
If your ability to repay the loan hasn't improved, “this can make a bad situation worse because the monthly payments will be even less affordable after the deferment,” FinAid points out.
You can avoid negative amortization by:
- Making payments (even small ones) during a deferment period. Ideally these payments should at least cover the new interest that accrues
- Increasing the term of the loan in order to reduce monthly payments
Overall, don’t throw money down the drain that could be used for a down payment on an investment property. Just remember to keep track of your student loans so they don’t grow into an even bigger money-sucking beast than they already are. Keep track of how many you have, know your principal payment and interest, and avoid deferment at all costs.
2. Be strategic with your credits cards
In your young life there will probably to two major relationships, your first credit card and your second. Hopefully you avoided perilous department store credit cards or college credit cards and selected something simple and affordable to get you started.
The second card is a gift to yourself. Now that you’ve built your credit, you can get the card that works for you. For most millennials this is something with maximum mileage points and minimal fees, but do a little research to find out for yourself. My first card was a standard college card from Wells Fargo with no introductory fee. The second was the Chase Sapphire credit card.
- Understand how your credit score works. The lower percent you owe on the max balance, the higher the score.
- Never carry a balance on your credit card. So far I am lucky to have dodged any drastic emergencies that would merit putting a giant balance on my credit card. If you can avoid having a balance and paying interest, that’s more money in your pocket.
Like I mentioned earlier, one of the great things about investing in rental properties is that you can own real estate outside of your local market. For example, the barrier to entry in markets like San Francisco, New York or Seattle is pretty colossal, but platforms like Roofstock make it possible to own rental properties in the Midwest and South where the price-to-rent ratio is much more attractive.
No matter what advice is written here, your journey to owning a rental property is going to start with your decision to make a positive change with your finances. There are plenty of resources on money management, but it will come down to you choosing a method that works for you and sticking to it.