One of my goals over the next 24 months is to find a larger house for my family of three. Our house is currently about 1,920 square feet with three bedrooms, two bathrooms, and a nursery. We built a 260 square foot deck off the master and have a small play area in our backyard.
After our house was battle-tested six times with relatives visiting since the birth of our son, we’ve decided it would be nice to have one more bathroom and 300 – 500 square feet of extra living space.
As a writer, I need a quiet place to hide and think. It’s important I separate where I write and where I sleep.
Besides, with a little Pavarotti in the making, our house is getting smaller by the month. Boy does my boy love to sing and talk.
Since purchasing our home in 2014, our income and net worth have luckily increased. We currently spend roughly 5% of our monthly gross income on all housing costs.
Based on my housing expense guideline for financial freedom, we want to maintain our monthly house expenses at no more than 10% of our gross income. Therefore, we feel it’s OK to purchase a house up to twice as expensive as our existing home.
For those of you who plan to buy a house in the near future, be it a first-time home or an upgrade, let me suggest a framework for how to invest your down payment or full payment while searching for your new home.
How To Invest If You’re Buying A House
The main variables in your down payment or full 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.
I’m also going to assume that everyone has at least a 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 and didn’t have sufficient cash left over to pay their mortgage once they got their pay cut or lost their jobs.
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 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.
Further, if they had taken out adjustable rate mortgages, they would have found mortgage relief as their rates adjusted lower.
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.
Time Of Purchase Is Priority
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 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 because you’re 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 because 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.
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 24 Months
If you’re planning on buying a house with the next 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.
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 2.5% from the remaining 75%, your House Fund won’t lose more than 6% in such a bear market scenario.
The positive of a bear market in stocks is that the house you’re looking to buy will almost certainly decline in value as well. If the house is declining in value greater than your House Fund is declining in value, you’re winning.
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 a healthy 2% or higher nowadays, I see no problem having 100% of your House Fund in cash for maximum flexibility and security. Knowing that you will increase the value of your house down payment or full payment by at least 2% with zero risk is wonderful.
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, down payment size, timing, a cold offer letter, or some other unknown reason. Chances are high that if you find your dream house, 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 a satisfying manner.
You will never be able to enjoy your stocks or your savings. But with real estate, you’ll be able to create wonderful experiences.
What I’m Doing With My Down Payment
After my House Fund appreciated by ~5% this year, I’ve significantly de-risked and now hold roughly 75% of the fund in cash. The cash is earning 2.4% in 3-month Treasuries and 2.45% in an online savings account.
I’m not willing to buy longer-dated Treasuries because the yield premium is not much higher (2.5% for 6-month Treasuries, 2.6% for 12-month treasuries etc). Further, I believe there’s a 55% chance I will buy another house within the next six months.
Because I see the Honolulu and San Francisco property market cooling off all year, I’m submitting under-asking offers on properties that have been sitting for over 30 days. One property in Honolulu has been sitting for three years! My goal is to put 50% – 100% down.
If I end up not buying a house this year, then my House Fund will likely end the year up 4% – 12%, depending on how the 25% position in tech-heavy stocks performs. I’m OK with forgoing upside gains because if I don’t buy a house in 2019, the chances of me buying a new house in 2020 go up.
The closer you get to buying your property, the less risk you should take. Stocks have an uncanny way of slowly going up during a bull market, and collapsing suddenly during a market panic.
I hope this post gives you a good framework on how to invest your down payment. Owning a wonderful home that you can afford is truly one of the biggest wins of your financial life.
Don’t mess it up.
Explore real estate crowdfunding: If you’re looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today. Fundrise allows you to invest in mid-market commercial real estate deals across the country that were once only available to institutions or super high net worth individuals.
Instead of taking a large concentrated bet in a single property, you can diversify across multiple properties with as little as a $1,000 investment each.