The elusive down payment. As we probably all know by now, this is one of the largest if not the largest barrier to first-time home buyers and keeps us in the vicious cycle of renting.
Mortgage payments? Piece of cake.
HOA fees? Can totally handle that.
Side fund for unexpected home repairs and routine maintenance? Got it covered.
Down payment? Yeah not so much.
How much do we need?
Let’s look at the average home cost for California. According to Zillow.com, the median price of homes currently listed in California is $499,950.
That would mean that a California resident would have to save approximately $99,990 for a 20% down payment for the median home price in the state. Yikes, sounds like a lot of saving and financial responsibility.
As you probably have guessed, accumulating the 20% “gold standard” down payment for a home can take many years of prudent saving and consistently being financially responsible.
So where do I start saving that money?
Throughout the process of building this substantial down payment fund you may have found yourself asking where is the best place to park this money as it continues to grow leading up to your first home purchase.
Well as always it depends on how long you have until this down payment actually arrives. Your individual time horizon as well as your individual tolerance for risk play a huge role in where you save the money.
Let’s take a look at a couple of the most popular options shall we?
Certificates of Deposit (CDs)
Bank Certificates of Deposit are a great way to ensure the safety of your down payment (subject to FDIC limitations) as well as guaranteed growth over a period of time. They are receipts of a deposit from a bank or other financial institutions with a fixed maturity date.
Typically the longer the term of the CD meaning the longer the financial institution has your deposit, the higher the interest rate that the financial institution is willing to pay you. The reason being that the longer amount of time you’re willing to “lock your money up” the larger you should be compensated.
They are backed by a bank and federally insured for deposits up to $250,000. Additionally, you are guaranteed a set interest rate from the financial institution in addition to the principal (the money your originally deposited) being returned to you once the CD reaches its maturity date.
The money you put into a CD has to remain in that CD for the full term of the CD. If the money is taken out before the term ends then you will be subject to early withdrawal penalties.
Be sure that the money you put in the CD is money you’re sure you will not need before the maturity date of the CD rolls around.
Also take note that many CDs offer pretty low interest rates when compared to other savings alternatives mostly due to the interest rate environment we are currently in.
High-Yield Savings Accounts
High-yield savings accounts are available to almost anyone and work similar in many ways to CDs. They are offered by financial institutions and your deposit is federally insured up to $250,000.
The main difference between savings accounts and CDs is that a CD has a maturity which locks your money in for a specified amount of time. A high-yield savings account on the other hand gives you full access to your deposited money without being subject to any early withdrawal penalties.
In other words, if you need the money you’re saving for a down payment for an unforeseen expense you can withdraw that money whenever you would like.
Savings accounts can provide a guaranteed interest rate as well as a guaranteed return of your principal. Your deposit is also insured up to $250,000 by FDIC Insurance.
As mentioned earlier, you have the ability to access your money at any time without being subject to an early withdrawal penalty which differs from a CD.
Some of you may be thinking why not just put your down payment savings in a high-yield savings account rather than a CD. After all, it works almost exactly the same as a CD without your money being locked up for a specified period of time.
You are correct… sort of.
The tradeoff with a high-yield savings account where you can access your money at any time is that the interest rates in these savings accounts tend to be lower than that of CDs.
Typically when you sacrifice your ability to access your money for a specified amount of time you are in turn expecting to be compensated more.
As with most things in life it’s all about tradeoffs…
Invest the Money
There is always the option to invest the down payment you’re saving in stocks, bonds or some combination of the two.
There is a caveat here so take note. Although you have the potential to earn a greater return on your down payment savings through investing it there is also the chance that the value of your down payment fund may decline.
If you’re starting to save your down payment and you see yourself buying your first home 8 or more years into the future then investing the money to potentially earn a higher return may be the most prudent choice.
If you’re looking to purchase your first home within a shorter timeframe of say the next 5 years then ensuring the safety of your down payment fund may take priority over extra earning potential on your money. As a result, the less volatile options of CDs or high-yield savings accounts may make more sense.
You have the opportunity to earn a substantially higher rate of return on your down payment if you invest the money in stocks, bonds or a mixture of the two rather than a CD or in a high-yield savings account.
Your down payment will not have a guaranteed interest rate, is not federally insured up to $250,000 and depending on what markets do while you have your down payment invested, you have the potential to lose a portion of it.
Some things of note
Putting 20% down for a home is generally considered best practice because if you put less than 20% down you will usually have to pay extra for PMI (private mortgage insurance) or government insurance which protects the lender if you cannot make payments.
Although 20% down for a house is widely considered the “gold standard” it isn’t the only option available. As more first-time homebuyers enter the market there has been a reduction in the average down payment amount.
Keep in mind there are programs out there that allow for buyers to put much less down than 20% on their home purchase.
At the end of the day where you save your money for your future down payment is really dependent upon your time horizon for purchasing your first home and your own tolerance when it comes to the amount of risk you’re willing to take.
As always, be sure to have all your financial ducks lined in a row prior to jumping into the wonderful world of home ownership. Additionally, I cannot stress the importance of consulting with a mortgage specialist to walk you through the complicated process of a first-time home purchase.
Neither Raymond James Financial Services nor any Raymond James Advisors renders advice on any mortgage issues, these matters should be discussed with a mortgage professional. This information is being provided for educational purposes only, it is not intended as specific investment advice. Please consult with a financial professional before making any investment decision.