How to invest the downpayment while you are accumulating it, till the time that you are ready to purchase the home.
As with many others investing decisions, how to invest the money that you are saving for the down payment on your home loan depends on how soon you expect to need the money. Not only is it about tying down the money for a long or short period of time, but also about the riskiness of more volatile growth oriented investment as opposed to choosing less volatile investment.
Typically, the longer you can afford to keep your down payment invested, the more growth oriented and risky investments you may consider such as stocks. For a shorter time frame, typically five years or less, choosing a less volatile investment is advisable.
This is simply because a volatile investment may see lots of ups and down and may only yield good return over a long period of time. By investing in less risky and conventional forms of investment such as market funds and certificate of deposits, you will earn more regular return and your principal is safeguarded. This is ideal when you know that you are going to need the money for the down payment in a short amount of time, typically within five years.
Investing the down payment money in stocks is a dangerous strategy. There may be a time when the market is on the rise and the yielding 20% to 100% result in a year. However, since this is a volatile market, it can just as easily crash and reduce the value of investment to even lesser than what you initially invested. This may leave you with no option but to wait for a longer period of time to purchase a home. Your expected home purchase may get delayed for years. Stocks are inappropriate investment for down payment money that you expect to require within the next five years.
The need to invest the money that you’re saving for a down payment comes from the fact that most people usually take a few years in order to come up with a requirement amount. During this time, it makes sense to put money somewhere where it can work for itself and grow. This itself will help reduce the burden on you to save the required amount for making the home purchase.
Downpayment Investment for five years or less
Unless you expect to buy a home in the next 7 to 10 years, you should not consider investing in growth oriented investments such as stocks. If you are like most prospective home owners, you are not in a position to take many risks with the money that you’re saving for the down payment. Sometimes, possibility of unexpectedly high returns and yields on certain stocks makes people greedy and think that they can double their down payment portfolio in just a couple of years. However, this is a highly risky proposition.
Although it may appear staid and boring, the best place for investing your down payment is probably in a money market mutual fund. Just like bank savings accounts, money market mutual funds do not risk your principal amount invested. This amounts remains the same and you earn interest on the money that you have invested. Money market funds invest in safe investments such as treasury bills, bank certificate of deposits and commercial paper which all short-term IOUs used issued by most creditors for corporations and companies.
Money market funds are one of the three types of mutual funds the other two being those that focus on bonds and those that focus on stocks or equity funds. Many people consider mutual funds to be as risky as investing in stocks. But it is true that the value of your fund does depend on market conditions but under the securities and exchange commission regulations, money market funds can invest only in safe security is and money funds investments must be made to have an average maturity of less than 90 days. This short-term nature of these funds eliminates the risk of money market funds being sensitive to the changes in interest rate in the same way that bond funds and stock funds are.
You may get a reasonable interest rate from a bank savings account. However, it will nearly always be less than the interest rate that you can get on the best money market fund.
If you do want to earn interest by keeping your money in a bank, look around. Smaller savings and loans and credit unions may offer you more competitive rates than the larger banks.
This could be simply because lower overheads mean more money to give to the investors.
Some of the best money market funds also offer a checkwriting facility. This comes in extremely handy when you need to access your money. The withdrawals also come in tax-free formats. If you are in a higher income tax bracket a tax-free money market fund may allow you to earn a higher effective yields than a money fund that pays taxable interest. But you should note that you pay tax only on money invested outside tax sheltered retirement accounts. When you’re in a high tax bracket but you are in a position to save by investing in a tax-free money market fund. This holds true if you happen to reside in a state with high income taxes. You can consider state money market fund which pays interest that’s free of both federal and state tax.
The best money market funds also offer several facilities like telephone exchange and redemption and automated, electronic exchange services with your bank account.
Automatic investment comes in handy for generating your down payment for home purchase. You can have a set amount of money automatically withdrawn from your bank account and into your money market fund every month.
When choosing a particular type of money market funds and such as general, treasury for tax relief, you’ll find different banks and competitors offering the same kind of bond but basically investing in the same security.
You can however choose and make a better decision by opting for the institution that has a lower overhead.
A money fund’s operating expenses which are deducted before payment of dividends are the major factor in determining a money funds return on investment. As with the high overhead of bank branches, the higher a money fund operating expenses, lower its returns. You can find excellent money funds from the best mutual fund companies for annual operating expenses of .5% or less. Listed below are some of the recommendations.
When you are not in a higher federal tax bracket and you are not in a high state tax bracket which means that you pay less than 5% in state taxes, consider tax money market funds for investing the downpayment money.
Municipal money market funds, also known as munis, invest in short-term debt issued by state and local governments. The municipal money market fund which pays you federally tax-free dividends, are issued by state and local governments throughout the country. A state’s district municipal fund invests in state and local government issued munis for one state, such as New York. If you live in New York and buy a New York municipal fund, the dividends on that fund are generally free of both federal and New York State tax. Sometimes your state may not have a good state tax-free money market fund available. If this is your situation, you are likely to be best off with one of the national money market funds.
State tax-free money market funds are a good option when you are in a higher federal tax bracket and the high state tax bracket which means that you pay 5% or higher. You can get in touch with the following mutual fund companies in order to see if they offer a fund for your state.
How to get in touch with mutual fund companies
It is quite possible that a mutual fund company does not have an office in your state or any local branch in your city. Generally this is done to help the mission fund company to keep the overheads low so they can pay greater dividends to the investors.
However, this does not mean that it is difficult to deal with an investment company which does not have a location near you. They have an efficient consume a cell which is open to service through toll-free phone numbers, e-mail and the Internet. Some fun provisos have branch offices in major cities as well. Here’s how you can reach the major mutual fund companies that we have earlier spoken about in this section:
Fidelity: 800-544-8888; www.fidelity.com.
T. Rowe Price: 800-638-5660; www.T. Rowe Price.com
USAA: 800 — 382 — 8722; www.USAA.com
Vanguard: 800-662-7447; www.van-guard.com.
Short-term bonds and bond funds
You may get the feeling that 3 to 5 years is a bit too long for your money to be put away in a money market fund. You might prefer to invest in bonds and bond funds instead. However, you should do well to understand that the returns on bond funds are heavily dependent on the market trend. There have been certain years in which bonds maturing in five years have got very little in the way of extra return as compared to a good market fund. During other periods, 3 to 5 year bond yielded a good deal more interest than a money market fund.
Whenever you invest in a bond that is not going to mature any time soon, you are taking on a risk that the interest rate may increase and unexpected inflation may cause the bond to pay less interest than the rate of inflation.
Most of the time bonds that mature in a few short years should produce a slightly higher rate of return for you than an average money market or savings account. However, you should still recognize the fact that you may end up owning the same or perhaps even less than you would have had you stuck with a money market fund. Rising interest rates can deflate the value of investment in bonds. Invests in bonds only if you expect to hold them for at least 3 to 5 years.
If you want to invest in individual bonds and you are not in a high tax bracket, you may consider treasury bonds which do not require monitoring of credit risk. Also look at the yield on bank certificates of deposit.
You may consider some high quality short-term bond mutual funds to invest in such as the Vanguard short-term investment grade portfolio. If you’re in a high tax bracket, a tax-free money market fund is extremely competitive and hard to beat when it comes to net returns. Some federal tax-free bond funds to consider include Vanguard short-term tax-exempt and vanguards limited term tax exempt funds. Double tax-free short-term bonds just don’t exist.
Investing the down payment for more than five years
If you expect to be saving and holding on to your down payment for more than five years, you can consider other risky investments such as bonds, stocks but keep in mind that you should try and take a conservative approach even in this scenario.
Do not get too greedy and take overt risks because at the end of the day, you do not want to lose the principal money and do not want your effort to save all the money for your dream home to have been in vain. When it comes to saving down payment for your dream home, the old adage does ring true, it’s better to be safe than sorry.