While most people dread tax time, if you are getting a refund, this time of year can seem almost as rewarding as end-of-the-year bonus season.
Whether you are receiving a refund of a few hundred dollars or several thousand dollars, if you’re contemplating buying your first home, you may want to deposit your refund into an account dedicated to your down payment fund.
“Using your tax refund as a portion of your down payment can be a great idea,” said Clint Madison, a senior mortgage adviser with Envoy Mortgage in Walnut Creek, CA. “The more you put into the down payment, the less you have to borrow.”
How Much Will You Get, and How Much Do You Need?
According to the IRS, the average refund for 2013 tax returns was $3,013 as of March 24, slightly higher than the average for 2012 tax returns. A tax refund of $3,000 can go a long way to a down payment on a home, particularly if you’re using an FHA-insured loan to finance the purchase since you would need just 3.5% of the home price for the down payment.
The required down payment on a median-priced home, which the National Association of Realtors says was $189,000 in February, would be $6,615 with an FHA loan. If you opt for conventional financing, you would need at least $9,450 for 5% down, $18,900 for 10% down, or $37,800 for a 20% down payment.
“Putting down 20% eliminates the extra cost of mortgage insurance,” Madison said. “Even a more modest 10% would improve negotiating power and can provide better interest rates than a lower down payment.”
Rich Arzaga, a certified financial planner, founder and CEO of Cornerstone Wealth Management in San Ramon, CA, says that since tax refunds are relatively small for most people, a refund may not be large enough to rely on as a centerpiece for the down payment.
“If you’re planning a few years in advance and you view tax refunds as a forced savings account, then saving two or three years’ worth of refunds along with savings from monthly discretionary cash flow is a serious way to help fund the down payment for a home purchase,” Arzaga said.
Is a Tax Refund Actually a Good Thing?
Arzaga pointed out, however, that the best tax refund is no tax refund.
“Most people view a tax refund as getting something back from the government,” Arzaga said. “Emotionally, it feels good. But practically, the taxpayer is getting the worse part of the deal by having the government give back the excess payment with no interest payment. The time value of money and the power of compounding make collecting the additional income and saving over time in an interest-bearing account a better deal.”
Other Uses for Your Refund
You may be tempted to use your tax refund for a splurge, but one of the best ways to accelerate your savings and improve your finances is to take “found money”—such as a tax refund or an unexpected bonus—and put it directly into your savings or to pay off debt. Before you do anything else with your refund, make sure you have at least a minimal emergency fund to cover your expenses for a few months or to pay an unanticipated bill.
If you have an emergency fund in place, then putting hundreds or thousands of dollars into a fund for your down payment, closing costs and cash reserves for home maintenance can be a great way to put you on the fast track to homeownership.
“First-time buyers will realize an even bigger tax refund in the next year because they’ll have a new write-off in the interest paid on their mortgage,” Madison said. “Add this to the prospect of equity gained through homeownership and it’s a win-win.”