Coming up with a sizable down payment is one of the key barriers to affording a home. Learning how to invest your down payment if you're planning to buy a house is a whole other issue.
On the one hand, you want to invest your down payment conservatively so that's it's available once you find your ideal house. On the other hand, you would ideally like to invest your down payment so that it grows even bigger. With a bigger down payment, you can lower your monthly payments or buy a nicer house.
This article will give you a framework on how to invest your down payment based on when you plan to buy a house. The longer out the timeframe, the more aggressive you can invest your down payment and vice versa.
I've been a multiple property owner since 2003. Let me share some of my wisdom about investing your down payment if you're planning to buy a home.
How To Invest Your Down Payment If You're Buying A House
The main variables in your down payment investment decision are: time, return, risk, existing cash, and cash flow.
Here are some assumptions to think about:
- The closer you are to buying a house the less risk you should take.
- The lower your risk tolerance, the lower risk you should take.
- The better your investing acumen, the more risk you are able to take.
- The higher your existing cash balance (down payment or full payment), the more risk you can take.
- The higher your cash flow, the more risk you can take.
- The higher the mortgage interest rate, the bigger the down payment you should make.
- The higher you expect mortgage rates to go, the pickier you should be.
- The more bullish you are about your financial future, the more leverage you may take.
- Investments should be made in investments that can become liquid by the time you want to purchase.
Everybody is at a different financial stage of their lives. Therefore, the one absolute variable we should focus on is the timing of your house purchase.
The Minimum Down Payment Amount
To follow my 30/30/3 home buying rule, everybody should have a minimum of 20% down payment plus a 5% – 10% cash buffer after the down payment.
If you do not have between 25% – 30% of the value of the house in cash, you cannot comfortably afford the house.
One of the main reasons why there was a housing crisis in 2008-2010 was because too many Americans put down 3% or less. Buyers didn't have sufficient cash left over to pay their mortgage once they lost their jobs. That's stressful!
Please don't put your financial future at risk while also jeopardizing your neighbor's financial future as well. Think of others.
Back then, many homeowners took out negative amortizing loans with no income verification and no down payments. That was the only way to be able to “afford” their homes.
If they had had a 5% – 10% cash cushion after putting down 20%, I'm certain the vast majority of homeowners who defaulted would have been able to keep up with their obligations.
Type Of Mortgage Matters Too
Further, if homebuyers back pre-2007 had taken out adjustable rate mortgages, they would have found mortgage relief as their rates adjusted lower. Nowadays, lenders are quite strict. Lenders are mostly offering 30-year fixed, 15-year fixed, 5/1 ARM, and 7/1 ARM mortgage. The days of negative amortizing mortgages are long gone.
Please, if you do not have between 25% – 30% of the value of the house in cash before purchase, getting to at least 25% – 30% should be your #1 priority. Work longer. Save more. Ask the Bank of Mom & Dad for a gift like so many adults do in big cities nowadays.
There once was a time when the majority of Americans purchased property with 100% cash. Therefore, don't think that it's unfair you can't buy a house without at least a 20% down payment.
In 2023 and beyond, we need to be more prudent when buying property given the mania has died down. People are remodeling for greater passive income. Owners were taking out HELOCs. Bidding wars were popping up all over the place.
You don't want to winning a bidding war frenzy because that likely means you overpaid at that moment. Try and stay disciplined. If you miss a property, there will always be another great one that will come along.
Time Of Purchase Is Priority When Considering How To Invest Down Payment
Now that we've agreed on the down payment and cash buffer, let's look at the main assumption. The closer you are to buying a house the less risk you should take.
I've divided the time of purchase into three segments:
- 5 years away or longer
- 2-5 years away
- Within the next 1-2 years
You should carve out an investment portfolio specifically for your house purchase. Let's call it your House Fund. Your House Fund is a separate after-tax portfolio from your pre-tax retirement funds like your 401(k), IRA, SEP IRA, Roth 401(k), 403(b), and so forth.
Compartmentalizing your investments for different purposes helps with motivation and risk-appropriate investing.
For example, you might be inclined to take more risk with your 401(k) since you won't be able to tap it for 30 years. The same type of risk is probably inappropriate for your House Fund if the down payment is due next week.
Buying A House 5 Years Away Or Longer
Let's say you're just starting on your House Fund journey. You're in your 20s and not quite sure where you want to live. You're also not quite sure what you want to do with your life. You know you'll eventually want to settle down, but not until you find a stable career.
Five years away or longer sounds about right. During this time, you also need time to accumulate your 20% down payment plus 5% cash buffer. You take the median price of the homes you'd like to buy, multiply it by 25% to come up with your minimum House Fund goal.
So much can happen in five years that it's impossible to know the future. You might not even want to buy a house five years later. Therefore, you should invest your House Fund as you would your retirement accounts based on your age or work experience.
Recessions generally don't last longer than 18 months. Therefore, if your time horizon is truly five years or longer, you have time to make up for your losses through savings and investment returns. You should always have 6-12 months of cash in a separate account by the way.
With a 5+-year time horizon, you can invest your down payment much more aggressively in stocks. You can also literally invest in a private real estate fund to better track the real estate market.
Buying A House In The Next 2 – 5 Years
You're pretty certain that you plan to buy a house within the next 2-5 years. You've found a stable job, a nice city, and maybe even a love interest to settle down with. You're excited about a future that is slowly getting clearer!
You're now much more focused on ensuring your down payment is always increasing. Therefore, it's only logical to dial back some risk.
At the same time, you might also be in the high growth phase of your career. Your income and savings have a tremendous ability to buffer investment losses in your House Fund.
You can adjust your House Fund investment allocation according to your financial health and your purchase time horizon.
If you're bullish on your financial future and don't plan to buy a house until year 4 or 5, then you can probably take maximum risk by going 100% in stocks.
On the other hand, if you work in an occupation with 0% – 3% annual wage growth in an industry facing structural declines, you may want to consider a maximum 50% stock allocation while boosting your cash allocation.
Buying A House Within The Next 12-24 Months
If you're planning on buying a house with the next 12-24 months, it's crunch time. You do not want to expose your down payment to potential market losses.
Even if you think you're still two years away from purchasing, because you're so focused on buying a house, there's a good chance you might buy one much earlier. Therefore, you should invest your down payment more conservatively.
For those of you who have a high risk tolerance and who have very strong cash flow, I suggest limiting your House Fund stock exposure to no more than 25%. This way, even if your 25% goes down by 30% in a bear market, the most your House Fund will lose is 7.5%.
But given you should earn roughly 4%+ from the remaining 75%, your House Fund won't lose more than 6% in such a bear market scenario. Besides, with Treasury bonds yielding 5%+, it pays well to be conservative.
Bear Market Positive When Buying A Home
The positive of a bear market is that the house you're looking to buy will likely decline in value as well. If the house is declining in value greater than your House Fund is declining in value, you're winning.
If you're deciding to upgrade to a more expensive home, you'll likely also winning even if your existing home is losing value. Real estate is cyclical. It's scarier to buy a home when prices are declining, but I'd much rather buy when prices are down and there's less competition than when there's a frenzy.
In a down market, you no longer have to waive your home inspection contingency to be competitive. Having the seller accept your offer with contingencies will feel great because your earnest money deposit won't be at risk if you decide not to buy. It's like getting a free call option.
Your bond allocation should be completely in short-term Treasury bonds, e.g., 3-month is likely best. Because it usually takes 30-60 days to close on a house on average, you don't want to tie up your money in longer-dated Treasury bonds. You can always sell before expiration, but by doing so you risk potential principal loss.
With money market accounts yielding more nowadays, you can also have 100% of your House Fund in cash for maximum flexibility and security. Growing your down payment risk-free is a good feeling.
Invest Your Down Payment Wisely
Buying a house can be a very emotional experience. There will be times when you put in your best offer and it's simply not good enough due to price. Or maybe your down payment size was too small. Or maybe you didn't write a nice real estate love letter.
Chances are high that if you find your dream house, many other people will like it too.
Therefore, it's wise to make your down payment as strong as possible. You'll already be stressed during the house purchase. You don't want to add to your stress by worrying about whether your down payment is sufficiently attractive to the seller.
If you've never owned your primary residence, you're in for a treat once you finally do. When you get your keys, you will experience a priceless feeling that nobody really talks about.
It's an amazing feeling to own an asset that not only has the potential to go up in value, but also provides utility every day. I truly believe for most people, owning real estate is one of the easiest ways to build long term wealth.
In contrast, you will never be able to enjoy your stocks or your savings. But with real estate, you'll be able to create wonderful experiences.
Down Payment Investment Recommendations
If you're looking at specific recommendations on where to invest your down payment, here are some to consider:
1) A high-yield savings account.
Unfortunately, the average savings rate is no longer very high because the Fed slashed rates to 0%. That said, the Fed is raising rates again over the next couple of years so money market rates should go higher.
2) A S&P 500 ETF.
I wouldn't get too fancy and pick individual stocks with your down payment money. I would invest your downpayment in an S&P 500 ETF like SPY, VTI, or IVV. They are all similar, low-cost ETFs.
3) A Treasury Bond.
I'd buy individual Treasury bonds with a 3-month or 6-month duration. You're guaranteed to earn the interest and get paid back your principal after the duration is over.
Alternatively, you could buy a Treasury bond ETF like IEF. IEF is the 7-10-year Treasury Bond ETF that is relatively stable. However, there is no maturity date, and your principal will fluctuate in value as you earn interest.
I wouldn't invest in individual municipal bonds as part of your down payment. Even though highly-rated muni bonds are tax-efficient and safe, muni bonds are expensive and cumbersome to sell. The market for individual muni bonds is not as liquid.
4) Real estate investments.
If you're looking to buy real estate and are still a ways out, you may want to invest some of your down payment in real estate investments. This way, you'll rise and fall with the real estate cycle. The last thing you want is for your target real estate to go up 10% while you don't participate.
Therefore, you can buy various real estate investments such as a publicly-traded REIT like VNQ or O. You can buy real estate-related companies like Home Depot, Redfin, American Homes, and Zillow. And you can also invest in real estate crowdfunding.
Favorite Real Estate Platforms
Take a look at Fundrise, one of the largest real estate investing platforms with over $7 billion in assets managed and 400,000+ investors. Fundrise primarily invests in the Sunbelt where valuations are lower and yields are higher. You can diversify across many properties in a real estate with as little as $10.
Fundrise has historically provided very steady returns. During bear markets or times of volatility, Fundrise returns have significantly outperformed. For most people, investing in a diversified real estate portfolio is the way to go.
If you are an accredited investor, take a look at CrowdStreet. CrowdStreet provides a way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations ad higher rental yields. If you have a lot of capital, you can build your own select real estate fund.
Both platforms are free to sign up an explore. I've personally invested $810,000 in real estate crowdfunding to diversify and earn income 100% passively. Real estate crowdfunding is like a Bonds Plus investment. It has higher yields, more offensive, but also has defensive during difficult times.
Shop Around For A Mortgage
When you finally are able to come up with a large enough down payment, shop around for the lowest mortgage rates online. You'll get multiple real quotes with no-obligation to sign in minutes.
You should also also contact your main bank and check their latest rates. Perhaps they can give you a loyalty discount or multi-account opening discount. If you have a lot of assets with the one bank, you may get relationship mortgage pricing as well.
Best of luck with your house hunt! Remember, your down payment is meant to be used as a down payment for a home. Don't use it as a stock trading account or do buy anything else! Otherwise, you may end up renting forever.
How To Invest Your Down Payment is a Financial Samurai original post. All rights reserved.