How do I save up for a first home?

I am a 23 year old living in Massachusetts. I am currently fully employed and living with my girlfriend who is also fully employed, although combined we make about $61,000 pre-tax. Both of us want to begin saving money so we can buy a home in the next 5 years, but we find it very difficult to do so while living in such a high-rent area. We both have a 401k and find that this is the most that we are able to put away. What are your tips on saving while living in an area with a high cost of living.
— Joshua, Boston, MA

You’ve probably already heard the usual advice for savers: cut back on dinners out, rent movies instead of going to the local Cineplex, cancel those premium cable packages.  Changing your spending habits, obviously, is an important and necessary first step. Everyone's budget is different, but to become a saver, you're going to have to get creative. (The other way to save more is to go make more money, but we’ll assume you’ve exhausted that track for the time being.)

The problem with the general advice about cutting back spending — or even getting anther job — is that you still have to agonize over each spending decision and carefully monitor your savings account to know whether you’re making progress. Most people don’t have this kind of patience or discipline. To get around that problem, our favorite approach is the Pay Yourself First system. If you haven’t come across it, it goes something like this:

Figure out now much you want to save — which, in your case means looking at some houses, asking about a mortgage and coming up with a down payment number. Then figure out how fast you want to save it. (The plan works for any other savings goal.)

Let’s say you want to save $20,000 over 5 years. To get there, at 5 percent interest on savings, you’ll need to put aside $67.65 a week, or $293.94 a month. (Weekly gets you there a little faster because compounding works harder.)  To change the target amount, use one of the calculators out there. We like bankrate.com)

The important thing is to treat that saving deposit like another involuntary paycheck deduction (like taxes). To set this up, go to a bank or mutual fund company, open an account and have them automatically deduct your savings from your paycheck (If they want to charge a fee for this, find another financial institution.)

The result is that you just gave yourself a pay cut; in your tax bracket, that’s probably about 8 percent of after-tax income. That means you’ll have to figure out how to make it through the month with 8 percent less money. No doubt this will entail some sacrifice; we have yet to come across a savings plan that’s “painless.”

The strength of this system is its simplicity. You never “see” the money you’re saving. But you know you’re going to reach your savings goal — as long as you don’t dip into that savings account or run up your credit card. Yes, this is going to hurt, especially at first. But there’s really no way around that. The confidence that you’re going to reach your goal should help keep you on track — and may help dull the pain.

If your savings goal is long-term (say, more than three years) you may want to consider moving some your accumulated cash into riskier investments like stocks to increase your return. A longer time horizon helps smooth out the market’s ups and downs, but you still risk losing some of your hard-earned savings. So a lot depends on how critical your goal is. The consequences of falling short in your quest for a big screen TV are a lot less than losing the down payment on a house for a growing family.

One other thing to consider: if you’re already saving in a 401k plan, you may be able to borrow against it for the down payment on a first home without paying any penalties. (To find out, check with your HR department or plan administrator.) But then tapping into your 401k savings before you retire sort of defeats the purpose of saving for retirement.

The problem you’re going to have (as we see it) is that in the “high-rent” housing market you’re living in, you’re going to have to stretch to find something affordable no matter how much you save. For someone in your shoes, this probably means finding a run-down “starter” home that you then fix up over time. (Shop carefully. There are “starter” homes and then there are “money pits” — so insist on a thorough inspection before you buy.) Or you may end up moving to a cheaper or more distant neighborhood to get started and then trading up as your income rises. That’s one reason average commute times are up — many housing markets have priced people out of housing near their jobs.

There are general guidelines for how much house you can afford, but they are only a starting point. In the end, the real issue is how much mortgage you can comfortably carry. There’s no easy way to do the math: a lot depends on your monthly costs, how much additional debt you have, etc. Bankrate has a pretty good calculator for that too.

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