Over the years, many people have inquired whether they should invest more or save for a downpayment. A home, after all, is usually the most expensive asset someone will buy in their lifetimes. Coming up with the downpayment is one of the biggest financial hurdles anybody can overcome. Furthermore, nobody wants to remain in a rental if they know they plan to live in an area for an extended period of time e.g. five years or more.
I’ll share with you my framework on how to figure out whether to invest or save for a downpayment. We’ll also talk through the decision process of deciding how much to invest in a pre-tax investment account like a 401k that has early withdrawal penalties before age 59.5, or invest in an after-tax digital wealth advisor like Betterment where you can easily get liquid without any penalties to buy your home.
INVEST OR SAVE FOR A DOWNPAYMENT?
The key thing to realize is that investing in the stock market and saving for a downpayment aren’t mutually exclusive. You can save for a downpayment by investing in the stock market. As you get closer to the time you want to buy, you can dial down your risk. Let’s first go through a mental framework about deciding where to allocate your savings.
Step 1: Answer The Why
The first thing everybody needs to answer is WHY they are making and investing their money. Hopefully the why goes beyond basic survival needs.
My #1 goal for making money since entering the workforce full-time in 1999 was to fill the Financial Freedom Bank with as much riches as possible. Work was rough for the first 10 years after college, and I wanted to do something entrepreneurial as soon as I had enough money to break free.
Step 2: Decide Which Is Better
Make a decision whether owning a liquid portfolio of stocks and bonds is more valuable to you than owning a place of your own. While you’re deciding between the two, you should also do your best to find your passion as quickly as possible.
From the age of 22 – 26, I preferred building my investment portfolio because I knew I wasn’t going to be able to last in Manhattan for five years. I had to get out ASAP. It was important my wealth was independent of geographic location. After 10 cold winters on the East Coast having also gone to high school and college in Virginia, I had to go west!
For many new graduates starting out, it’s highly unlikely the first job you take will be the last job you’ll ever have. Very few are so lucky, or so unadventurous as to stay in one place forever. Consequently, I advise trying to save and invest as much money as possible in your 401k and after-tax brokerage accounts first.
Step 3: Mobilize Your Capital
After growing my investment portfolio to about $250,000, I started feeling this emptiness for work inside. I escaped Manhattan for a new job in San Francisco, but just three months later 911 happened. Working in finance didn’t feel meaningful anymore. Seeing the investment account grow wasn’t motivating either because the portfolio provided little utility. Due to the volatility post dotcom burst and terrorist attack, I wanted to convert funny money into a real asset.
Because of my investment portfolio’s lack of utility, and because I, at the age of 25, no longer wanted to live in a cramped one bedroom apartment with my girlfriend next to an alcoholic neighbor, who would blare the bass all evening, I decided to put $120,000 down on a $580,000 2/2 place that overlooks a park in Pacific Heights.
As soon as I got the keys (and the first mortgage payment), my motivation to work shot through the roof. Finally, I was deriving some utility from the money I was making and saving: a nicer place to live! Having a better lifestyle was my main goal for having more money.
I liked living in my own place so much that two years later, I bought and moved into a new place. During the times between real estate purchases, I continued to invest all my savings based on my recommended stock and bond split.
CONTRIBUTE TO 401k OR SAVE FOR A DOWNPAYMENT?
Deciding on whether to contribute to a 401k or create a Downpayment Fund through an after-tax digital wealth advisor or online brokerage all depends on your income, timing, and liquidity needs. In general, it’s always best to be as liquid as possible. However, you don’t want to not take advantage of free money.
If You Can Afford To Max Out
For those of you who make more than $50,000 a year per person, I strongly encourage all of you to max out your 401k, whether there is a company match or not, and then try and save/invest an additional 20% of your after tax income. The more you can save the better obviously. For those making $50,000+ income, there should be no excuses for not maxing out your 401K. For 2019, the max limit is $19,000, up from $18,500 in 2018.
You not only allow your investments to grow tax deferred in your 401k, you will also wake up years from now with a investment portfolio larger than you could have imagined because people are generally very undisciplined when it comes to money.
It’s the old “where did my cash go” a day after withdrawing money from the ATM machine phenomena. By automatically contributing to your 401k per pay check, your base case scenario is likely at least a $180,000 401k portfolio in 10 years. You learn to live with the income you have. Below is a chart of what you could have in you 401k if you saved diligently.
If You Cannot Afford to Max Out
For those of you who make less than $50,000 a year per person, I strongly recommend contributing at least to the employer 401k match. For example, if you make $40,000 a year and the employer matches up to 3% of your base salary, contribute at least $1,200 a year so that each year, you’re adding at least $2400 to your 401k. You always want to take advantage of a sure thing. If you value having an investment portfolio more than buying a home, then feel free to contribute more than the employer match.
For those who value buying a home over building an investment portfolio, or can see themselves valuing a home over an investment portfolio in several years time, then all disposable income after contributing to your 401k match should go to an after-tax investment account based on a stock and bond allocation framework.
Convert Risk Into Risk-Free
The farther away you are from purchasing your home, the stronger you should stick with the asset allocation framework. Once you are within one year of purchase, I would shift your downpayment money to a 50/50 equities/fixed income split at most. Please note that bond ETFs like IEF do well during a stock market downturn. The closer you get to actually buying a property, the more you should consider converting your downpayment money to 100% cash. Given you will continue to save and invest each month, you should theoretically be always boosting your savings.
Deciding when to de-risk your downpayment investment money is an individual choice that depends on your risk tolerance, investing ability, and income stream. One good rule of thumb I use is the 10% rule. If your annual after tax savings can easily make up for a 10% decline in your downpayment investment portfolio then you probably can afford to keep allocating based on your preferred asset allocation.
Worst Case Scenario
If you end up needing to raid your 401k for a downpayment, then you can borrow up to $50,000 or half the value of your 401k, whichever is less, at a higher interest rate than a mortgage. Just know that you have to pay back the loan within 5 years or within 60-90 days if you leave your company. Worst case, you can completely liquidate your 401k for a tax and 10% penalty if you are under 59.5.
I think only petulant fools borrow from their 401ks. Have the discipline to want less, or buy a home only after you can comfortably come up with a 20% downpayment. Remember that the downpayment is only one expense. Don’t forget property taxes, maintenance expenses, and your mortgage as well.
- Build as large of a savings/investment portfolio as possible via your 401k and after-tax investment accounts through automatic investment contributions. You don’t want to be tied down with an illiquid asset like a house early in your career because chances are very high you’ll have a new job in a new location in your 20s.
- Only after you’ve found a place where you can envision yourself living for at least five years, is it time to aggressively shift savings towards after-tax investments for your downpayment. The ideal scenario is if you can max out your 401k while saving as much as possible after taxes and 401k contribution.
- If money is tight, at least contribute up to your company’s 401k match. Never say no to free money.
- Once you are within one year of accumulating enough to buy a home, convert the asset allocation to at most a 50% equities allocation. Within a year, you should convert your entire downpayment investment fund into predictable cash while continuing to save new money every month.
- Don’t use 100% of your entire liquid assets toward the downpayment. You need to have a buffer in case things go terribly wrong after purchasing the house e.g. job loss, investment loss, medical emergency, etc. Come up with a 20% downpayment and have at least a 5% cash buffer e.g. $100,000 downpayment on a $500,000 house and at least $25,000 cash buffer.
During your saving and investing journey, always be mindful of your WHY. Knowing your WHY will make delaying gratification and choosing between investing or buying a home easier. Instead of seeing the process of saving and investing as a sacrifice, treat saving and investing like a game.
Wealth Building Recommendations
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Updated for 2020 and beyond.