Where should you save your down payment for a house?
There are tons of articles and blogs trying to answer this question. I’m not happy with any of them.
I’ll try to answer this my way.
The Rich on Money way.
There are two main factors that will influence where you should invest your downpayment for a house.
The first is how certain you are in what timeframe you will need that money. Are you for sure using it within the next year? Not much of a reason to put it at risk.
Are you unsure if you will purchase something in the next several years, but want the option?
Maybe you should consider putting some of that money at risk instead of just letting it sit there not working for you.
The next factor is your risk tolerance.
Some people understand that by putting their down payment in the stock market or a mutual fund, they run the risk of either having it grow quickly, or the opposite, losing half or more of its value quickly.
Could you live with that tradeoff?
If not, go with the less risky options, even if you are not sure when you will purchase a house.
Also, there’s what I ended up doing in my life.
I’ll explain which one of these methods I ended up using for my money.
It’s one that could have backfired on me big-time, but luckily didn’t.
Let’s look at the least risky options first.
These are obligations of the federal government that mature in one year or less. There are virtually risk free and back by the U.S. Government!
To make these worthwhile, you usually need to purchase a shit-ton like $10,000 or more. Also, you gotta keep them for at least a year, and their yield is lower than an on-line savings account, which I would recommend over this.
Verdict: These aren’t very liquid, and not enough reward.
HIGH-YIELD ON-LINE SAVINGS ACCOUNTS
For one reason or another, you may decide that preservation of capital is king.
The important thing may be not losing the down payment you have, even if that means giving up gains you could have made in the market. The idea of losing the down payment you already have is too painful.
It’s a risk you don’t want to take.
The best way to do this with a half-way decent interest rate is in a high-yield online savings account.
Online banks don’t have the expense of maintaining branches, with building, employees, salaries, A/C, etc. This means they can pay more interest!
As of October 2018, you can get interest rates upwards of 2%.
This is a lot higher than the national average of 0.09% for savings accounts.
Verdict: These are liquid, and a have a good interest rate for no risk. They are FDIC insured, so the money is safe.
For specifics, see Nerdwallet’s Best High-Yield Online Savings Accounts of 2018
MONEY MARKET ACCOUNTS
Money market accounts work a lot like savings accounts. They still come with FDIC insurance, which insures your deposits $250,000 per account and depositor. They invest your money like mutual funds, but in low risk investments like government bonds.
Like the category of high-yield online savings accounts above, you are going to see rates around 2% right now. Not bad.
Read the fine print. There may be minimum deposits, monthly service fees, etc.
Verdict: The same as savings accounts. Good rate for no risk and a better-than-nothing interest rate. You’ve got liquidity.
A list of several options are listed on TheBalance.com’s website.
CERTIFICATES OF DEPOSIT (CDs)
This is probably your next tier of getting a higher interest rate for your money, but losing the ability to instantly access that money (liquidity).
CD’s are investments where you give the bank or credit union a set amount of money for a certain amount of time, and you get that money back plus the agreed on interest rate at the end of the set period. The interest rate gets higher for longer deposits.
As you can see from our two categories above which are essentially savings accounts, you can get around 2% with those.
With a 1-year CD, you might get 2.5%. 3 to 5 years, a little more than 3%.
You get penalized financially for taking out the money early.
Verdict: I don’t know if the lack of liquidity is worth the trouble. You’ll have to decide that for yourself. It’s not much higher than a savings account.
I need some flexibility for my investing.
Click here to see Nerdwallet’s Best CD Rates for November 2018
You could invest your potential future down payment in a brokerage account of some kind. It could be either in stocks, mutual funds, or any combination of the two.
There are definitely pros and cons to this idea. You could make a lot more money if you invest well, but lose a lot if you suck at investing (or just guess wrong).
Let’s go with the broad definition of investing in the market in general.
It is widely accepted that, on average, the “market” has made about 8% on average per year. This is WAY better than what you will make messing around with 2-3% on those piddly savings accounts or CDs. This is especially true when you consider the magic of compound interest on top of that!
So, I’m a huge advocate of simply investing in index funds such as the S&P 500 Index or Total Stock Market Index which I talk about extensively in my post on the Cheapest Index funds.
If you throw your money here, let it grow at 8% a year for 4 or 5 years, and then use it for a down payment, you’ve made a bunch of extra money, right?
You are going to make 8% a year on average. It depends which 4 or 5 year timeframe you are talking about.
The shorter the timeframe you are talking about, the less likely you will actually see that 8% average we are talking about!
I like to use the example that, if you can’t swim, you should probably not try to cross a river that is 4 feet deep on average.
There are years the market is down 40%, as well as up 30%. Can you stomach losing 40% of your down payment one month before you want to purchase your dream home?
Verdict: It’s risk tolerance. It’s how bad you need all that money now. If you are willing to risk the down-side in able to make money on your potential down payment over the long run, give it a shot. Understand the risk.
In my situation, this is the method I used throughout my entire investment career. From 2000 to present day, I’ve kept all my extra money invested in index funds. When it was time to purchase a property (and I usually paid cash), I sold my index fund, and used that cash to buy the property.
I saw a huge downturn in both 2001 and 2008 in the stock market, but on average, I’ve made out well over the long run with this method.
Also, I’m debt free, have no mortgages, and in a very good place financially. If I did lose a bunch of money in the market, I wouldn’t freak out, it wouldn’t be everything I have. It wouldn’t be my life savings.
I have a high risk tolerance for downpayment money.
But do you?
Everybody has to make that decision for themselves.
Are you at a place in your life where you are willing to put your down payment at risk? If you already have 4 houses and this is your 5th, maybe.
If you are working three jobs as a single mom scraping together your first downpayment ever that will pull you out of poverty, let’s be careful with that down payment!
In reality, you are something in-between. Make your call on what you’re comfortable with and save your money appropriately. I didn’t list every possibility, just some of the most obvious ones that I would recommend.
To get a headstart on all this stuff, read my Complete Guide to Real Estate Investing.
RICH ON MONEY