So, You’re Saving For a House. Where Should You Keep the Down Payment Money?

The average first-time homebuyer puts down 6% of the property’s value at closing, according to the National Association of Realtors. So on a $300,000 home, for example, a typical buyer will save $18,000 before they become property owners. And to cover 20% of the sale price? You’d have to scrape together a cool $60,000.

The sheer size of a down payment creates a conundrum, especially for those saving up for their first home. You probably don’t want that money subjected to the whims of the stock market, which can take a dip at the very moment you find your dream home. But you’re probably not crazy about your funds sitting in an account that generates a razor-thin interest rate, either.

So, Where Should I Keep My Down Payment?

So where’s the best place to put a down payment? Well, that depends on two critical factors, according to Dan Herron, owner of fee-based Elemental Wealth Advisors in San Luis Obispo, California: The first is your timeline for making a home purchase. The other is your tolerance for risk.

Unfortunately, growth potential and volatility very much move in the same direction, which future homebuyers have to think about when considering stocks and other securities. “If having that money invested makes them lose sleep, then they should be conservative and keep it in a high-yield savings account,” says Herron.

Don’t let the name fool you. In this low-interest rate environment, don’t expect any gargantuan returns from those online savings vehicles — Ally and Marcus both offer 0.50% APY at the moment (although that likely beats your bank down the street). But because most savings accounts are FDIC-insured, your principal is safe as a kitten.

What About Using Investment Accounts?

For those who are a bit gutsier, or have a longer period before they buy, allocating part of your home-purchase money to investments can help increase your upside, says Herron. The rest should remain in a savings account that creates a ballast for your brokerage funds.

If you have a 3- to 5-year window before buying, Herron recommends steering the investment portion of your down payment towards more conservative investments like high-grade bonds (Herron likes the iShares Core U.S. Aggregate Bond ETF and Vanguard Total Bond Market ETF) and municipal bond funds (for example, the Vanguard Tax-Exempt Bond ETF or iShares National Muni Bond ETF).

Which fund makes the most sense largely comes down to your tax bracket. Because the interest that munis pay is typically exempt from federal tax, households in higher brackets generally get a larger benefit from these government bonds than lower income-earners. Herron says he also likes to incorporate short-term bond funds in his client portfolios to reduce the volatility from future interest rate hikes.

And folks with a slightly longer window—say 5 to 10 years? Though they’re more volatile in the short-term, adding a diversified stock fund to your mix allows the potential for juicier rewards. Another option: low-volatility funds that invest in a broad range of equities but seek a steadier performance than the S&P 500 as a whole. Typically, these funds lag the market during an upswing, but soften the blow when things are moving in the other direction. That’s a trade-off a lot of future homebuyers would be willing to make.

As for the proper ratio of savings to investments? “It all depends on how much the purchaser wants to risk,” says Herron. Obviously, the more money you contribute to stocks and bonds, the more your holdings can fluctuate.

Any time you’re using brokerage accounts, it’s important to think about the potential tax consequences. This is another reason why you probably want to steer clear of investments if buying a home is right on the horizon, says Herron. On top of exposing yourself to potential market fluctuations, you’ll have to pay the more punitive short-term capital gains tax on anything you sell in under a year, cutting into your net proceeds. So you’re really putting yourself in a financial no man’s land.

How Much Should You Put Down on a House, Anyway?

Buyers with decent credit can often snag a mortgage with as little as 3% down — and with some programs, even less. Whether taking on a bigger loan is the financially wise play is another matter.

The big question is whether you can really afford the ongoing costs of homeownership once you sign the closing papers. A lower down payment means a bigger monthly mortgage payment, which can be a big strain on first-time buyers.

“I typically recommend that you try to get a payment that’s close to what you’re paying in rent already,” adds Heron. “This makes the transition from paying rent to paying a mortgage pretty easy.”

But that means keeping your total monthly expense, including fees you put in escrow, roughly the same. In addition to the mortgage payment itself, you’ll need to account for:

• Mortgage Insurance (if putting down less than 20%)
• Property taxes
• HOA fees
• Homeowners insurance
• Repairs (typically 1-2% of the purchase price every year)

You also want to think about the effect of a home purchase on your other financial goals, says Herron. For instance, can you make the house payments and continue to adequately fund your retirement account or your child’s 529? And if you’re dipping into your emergency fund to make your down payment, how long will it take to replenish those funds?

“It’s important that you truly understand the impact of a home purchase impacts your financial well-being,” says Herron. “It’s not like a pair of shoes that you can return if you don’t like them anymore.”