How to invest a house downpayment fund

Our previous post on emergency funds got a lot of traffic and we received mostly praise for the post (see here and here). One issue mentioned by some that got us thinking is how to save for a house down payment or some other large expense in the future. Should we apply our same rule as for the emergency fund, i.e., invest it all in risky assets to get greater expected returns and avoid opportunity cost? Or is this a different animal from an emergency fund?

Since we still can’t time the stock market we would lean towards keeping money in stocks until it’s time to withdraw. So we first make a case in favor of equities. But we concede that there can be situations where you want to take less risk, say, where you could lose your dream house if you are short even a single dollar in your down payment fund, so we present some options for that scenario as well.

Under what conditions is it acceptable to invest your down payment fund in equities:

• You are starting from $0.00. It will take some time to get the down payment together, so use the power of compounding and regular savings in your fund to grow it faster. In general, whether you start small or already have a sizable fund, if the planned purchase is many years in the future, equities are the way to go. Equities might go down for a while, but over longer horizons have always outperformed cash and even bonds.
• You have flexibility in the purchase date and purchase price. So what if the stock market tanks? If equities are down 30%, it may not be the best time to buy a house anyway. Do you want to have that albatross of an illiquid asset and a mortgage during a recession? Maybe wait until the dust settles and the market recovers. The experience from the previous market crash was that the housing market lagged the stock market. Equities recovered from their low faster than the housing market in many cities. Why not sit on the sideline for a while, let your equity portfolio recover and buy a house at a bargain price?
• You have a sizable financial net worth, many times larger than your projected down payment. Imagine you are worth $1,000,000 and like to use $100,000 for a down payment at some point in the future. If you get your pants in a knot over fluctuations in your small down payment fund, are you sure you should be invested in equities at all? Example: If you keep all in equities and suffer a 30% loss you have $600,000 left in your equity portfolio (lose 300k, withdraw 100k for home purchase). If you had shielded the down payment fund in a money market account you’d have $630,000 left in equities (900k minus 30%). In one case your value dropped by 37% in the other by 40%. Not a huge difference. Also, don’t forget, you might get that dream house of yours at a significant discount at that time. Maybe not for 30% less, but maybe 10-15% under what you had planned to spend. Moreover, you might get your mortgage for a lower rate if the Federal Reserve goes the route of the ECB or BOJ once the next recession comes along. Think of your household financial risk management in a holistic way, not within each bucket separately!
• Financial engineering: Do a covered-call writing strategy, i.e., sell some or all of the upside potential of your stocks for extra yield. You still maintain the downside risk, but as we noted above, if the market really tanks, maybe it’s best to not jump into the housing market at that time anyway. Check Amber Tree Leaves for the basics on covered call writing. He also has a nice general intro to option trading. We also wrote a piece on option writing as a way to generate passive income.

If you absolutely don’t want to be in equities, here are some other alternatives

• Longer term bonds with higher yields. But: if interest rates go up bonds can lose a lot of value too! It could be a double-whammy: your bond portfolio loses value and you will likely face a mortgage interest rate hike. Ouch! Alternatively, a large inflation shock could send home prices up, mortgage rates up and your down payment invested in nominal bonds down. From a pure risk management perspective, long-bonds seem quite unattractive when saving for a house down payment. Again: Think of your household financial risk management in a holistic way, not within each bucket separately!
• Corporate bonds but with a shorter duration, with less interest rate risk. But now the best you can hope for is a few basis points over the money market account/CDs.
• Rolling your money market account from one promotional offer to the next. Might be a big hassle and not worth the few extra dollars of income. But our friend at Fifth Wheel Physical Therapist had some nice suggestions on how to milk the system, see here and here.
• Municipal bonds (via ETF or mutual fund). If you are in a high tax bracket, at least shield the measly income from the tax-man! But caution, some of the higher-yielding Munis with good rates also have big interest risk.
• A hybrid strategy: Consider a portfolio of 40% stocks and 60% bonds (as opposed to 60/40 Stocks/Bonds). Bonds, especially government bonds, are a pretty good diversifier for short-term fluctuations in equities. 7-10 year treasury bonds yield around 1.6%, equities have 2% dividend yield and some potential for capital gains. If price fluctuations balance each other out, there is a good chance you beat the 0.5% in a money market account. And dividends are taxed at a lower (or zero) federal rate! Play with the stock-bond weights and see how different mixes performed during the past scary periods. A 40/60 already looks very different from an equity portfolio or even a 60/40. If 40/60 is still too scary and volatile, go to 30/70. But recall: too much bond risk is bad, due to the bad correlation with mortgage interest rates, see above!

As with all posts on investing, our disclaimers apply.