How To Help Your Kids Buy A Home In A High Cost Area

I recently wrote about how my oldest son bought a house 1 year out of high school.  He was able to buy his home without a cosigner and without a down payment gift from his parents.  We live in a low cost of living area and he paid $64,000 for this home.   My sister lives in Silicon Valley and her kids will likely have a much harder time purchasing a home than my son did, even though wages are higher in that area.

I think most parents want their children to be able to live in their neighborhood, or at least in their city. While it is a struggle for all young adults to purchase a home, it is much more difficult for those living in expensive cities.

The Problem:

In the Silicon Valley area an entry level starter home is currently around $1,000,000.  For a home needing significant repair like my son’s the price would probably be around $800,000.  In order to buy a $1,000,000 home the following needs to be true:

Excellent Credit Score:

Credit scores influence the lending rate substantially.  The difference between a mediocre credit score that qualifies for a loan and an excellent credit score may result in a 1.5% difference in interest rate.  on a $50,000 loan like my son’s this amounts to around a $50 difference in monthly payment, which is not overly significant.  On a $900,000 loan this is a $900 difference in monthly payment.  At these prices the interest rate matters A LOT. A lower credit score also increases the points needed to be paid by the borrower. For someone with a 640 credit score they will typically pay about 2% more than someone with a 740+ credit score at closing.  For A $1,000,000 home this is $20,000!

Down payment Cash:

For a $1,000,000 home the down payment needed is as follows:

  • 3.5%: Minimum FHA : $35,000
  • 5%: $50,000
  • 10% $100,000
  • 20% $200,000

In addition to a larger down payment making the loan amount and thus the monthly payment smaller, a higher down payment also reduces loan level pricing closing costs.

Work History:

Must have 2 years of solid work history. Pretty straight forward.

No Debt:

Since it is likely young adults will be on the higher end of debt to income ratio for a home purchase in California, any other monthly debt payments are massive inhibitors to getting a home.  The balance sheet must be clear of other debt, such as credit cards, student loans, and car loans, to ensure they can qualify for a mortgage. For mortgages the banks look at both the total cost of the monthly mortgage payments and the total amount of all monthly debt payments.  Every $1 in debt payments reduces your available monthly mortgage by $1.

High Earnings: 

To qualify for a mortgage total DTI (Debt to Income ratio) must be below 45%.  This means for someone earning $100,000 per year, their total debt payments can not exceed $45,000 per year or $3,750 per month.

Assuming that interest rates will go back down into the 4% range in the future,  a 30 year 900K mortgage will be around $4,297 per month. Add in $800 a month for property taxes and we get to around $5,100 a month, requiring an income of around $136,000 a year to qualify.  This is roughly 3.5 times the income my son has that qualified him for a loan in our area.  As an hourly rate $136,000 a year is $68 per hour.

These are some extremely difficult bars to overcome.  Both my sister and her husband are college educated, hard working, and career oriented.  They both worked in professional jobs but were unable to purchase their first home until they were in their mid 30s.

What To Do:

1. Credit Score:

Add them to your credit cards.

Adding your children as authorized users to your credit cards gives them the entire positive history of that card.  When I added my son to my credit card I have had for 10 years, his credit reflected him having a credit card in excellent standing with low credit utilization for 10 years, giving him a credit score of above 770 instantly! This costs nothing and is easy to do, of course you need to have credit cards with excellent history for this to work.

2: Down Payment

Allow your child to live at home longer.

This will save them from paying high rent and allow them to build up a large cash cushion.  They should be required to be saving 80% of their income while living at home.

For an adult at a higher tier entry level job in the San Jose CA area, $30 per hour is not unreasonable.  Earning $60,000 per year and saving $48,000 per year for 3 years would ensure a decent down payment and a buffer.

If they move out right after high school they will immediately be spending the majority of their income on rent, even if they do have a room mate.  Let them live at home as long as possible. This costs you very little while giving them a major advantage.

529 to Roth IRA to Down Payment Hack

If your child is very young set up a 529 plan for them and fund it at $100 a month for 12 years.  By the time the account has existed for 15 years they can start converting the money inside it into their Roth IRA up to $35,000 total.  Roth IRA contributions can be withdrawn at any time and all of these conversions are contributions.  An additional $10,000 of earnings can be withdrawn for a first time home purchase and taxes will be due on this withdrawal, but no penalty.

Have them work while in high school and bank cash.

Banking 80%+ of their gross income will build up the war chest they need for a down payment, and having work experience in high school will help them be more competitive in the market for a higher paying job when they get out of high school. Better yet, have them finish high school early.  High school and K-12 schooling is an absolute joke.

My 14 year old did young 5s and would not be on track to graduate until right before he turned 19.  We tried to get his K-12 school to provide a feasible option for graduating early, but they were unable to provide a clear path.  We pulled him from the school and he did his 8th grade year online.  For 9-12 he will be doing Penn Foster’s online high school program.  It costs $1,400 total, the AVERAGE student finishes in 15 months, and a fast track student can finish in 6 months.  Rather than waste 4 years going to K-12 schooling, it can be completed in a single year.  Giving your child 3 years of time back can make it much easier for them to launch in life.  Think about it this way, if your child can earn $30,000 per year working rather than being in school and saves 75% of it, having those 3 years free from High School allows them to save $67,000! No 18 year old’s have $67,000 saved!

Completing high school at 15 would allow them to do some skills training courses that take a few months like coding boot camps, and then get a real job.  In most states as long as your child is 16 and has a high school diploma they are exempt from child labor law restrictions and can get “real” jobs.  It’s much easier to save for a home and qualify for a mortgage when earning $40 an hour as an entry level programmer than earning $15 per hour working at a fast food restaurant.

Down Payment Gift:

If you have the financial means to assist with a down payment gift, this can go a long way towards eliminating the down payment as a barrier to home ownership.  Consider gifting a matching contribution towards the down payment.  Each year each person can gift a maximum of $16,000 to another person without having to file a gift tax return and count against their lifetime gift / inheritance tax. With 2 parents this could be $32,000 a year towards your child’s down payment. Plan ahead to maximize this exemption, it is better to give $32,000 a year for 3 years than to give $100,000 in 1 year from a gift tax perspective.

High Earnings Required:

Assist Your Child In Career Development:

We already talked about having your child finish high school early and work during high school.  Spend a few hours each month with your child on skill development that can result in increased earnings.

 Encourage your child to purchasing a duplex. 

The rental income can count directly $1 for $1 against the mortgage.

As an example this Duplex is a 3 bedroom 1 bath on 1 side and 2 bedroom 1 bath on the other side.  This would be a great starter home.  Someone could rent out the 3 bedroom side for $3,000 a month and live in the 2 bedroom side. It doesn’t have to stay a duplex forever, your child could relatively easily convert the house back into a 5 bedroom 2 bath single family home in the future when his or her income increases and the rental income is no longer needed.

Using this house for an example, purchasing with a 10% down payment would be

  • $1,150,000 purchase price
  • $115,000 down payment
  • $1,035,000 loan
  • $4,941 Monthly mortgage at 30 years 4%
  • $814 Property taxes
  • $200 Home owner insurance
  • -$3,000 Rental Income
  • $2,955 debt payment after rental income

Income needed to qualify for a total house payment of $2,955 at 45% DTI would be $78,800 per year in income outside of the $3,000 rental income.  This is a much easier income bar for a young adult to get to than the above discussed income of $136,000 per year for a $1,000,000 home.  $78,800 per year is the hourly equivalent of $39.40 per year.   This is doable.  It is extremely doable if your adult child is purchasing a home with a significant other who also works.

NOTE: Ensure that a buffer of at 6 months rent ($18,000) is maintained in cash, as CA rentals take a long time to evict if needed.

Encourage Them to Marry Young:

Qualifying for a mortgage is a million times easier for 2 people working together than 1 person by themselves.  1 person purchasing a home in this area will be very difficult.  But with 2 incomes hitting the required income thresholds will be possible much sooner. There are other reasons to marry early and a host of others to marry later.  In terms of buying a home, 2 incomes is certainly better than 1.

The Extreme Option:

Buy a Home Now For Your Children:

Use the duplex example and rent it out.  The 3 bedroom side would earn around $3,000 per month, while the 2 bedroom side would earn $2,200 per month,  leaving a monthly shortfall of around $750 without counting maintenance, which we will put in at $250 a month to make the math easy.  This brings us to -$12,000 per year in cash flow. Certainly not ideal, however homes in this area have been increasing at a rate of well over 5% per year, so equity of over $50,000 should be gained each year, despite the negative cash flow.

Another option to get positive cash flow would be to turn this property into a short term rental. Other rentals in this neighborhood are renting for around $200 a night for a 3 bedroom and $170 a night for a 2 bedroom.  Apply a 70% occupancy rate and we are looking at monthly income of $7,700.  This brings us up to positive cash flow of around $1,500 per month. Use this $1,500 a month to pay down extra on the principal.

Buying this home now and using it as a short term rental for a decade does several things:

  • It insulates your child from prices increasing further
  • It pays down the debt on the home
  • It allows you to seller finance the home to your child at favorable terms; i.e. taking over the payments rather than getting a new loan and a massive down payment.
  • $1,150,000 purchase price
  • -$172,500 down payment
  • $977,500 balance
  • 10 years in with no extra paid on principal balance would be $770,000
  • Paying $1,500 a month down on the property reduces the debt to $545,000 in 10 years.
  • Paying $1,500 a month down on the property reduces the debt to $256,000 in 15 years.

You are then fully in control of the asset and can decide the terms for selling the home to your child.  This could be at a discounted purchase price, better terms, or both.

What do you think about these ideas for helping your children buy a home in a high cost of living area?

John C. started Action Economics in 2013 as a way to gain more knowledge on personal financial planning and to share that knowledge with others. Action Economics focuses on paying off the house, reducing taxes, and building wealth. John is the author of the book For My Children's Children: A Practical Guide For Building Generational Wealth.

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