A common frequently asked question that I receive concerns saving money to buy a house. This involves some variation of what is the best way to save money for a house? Should I save money for a house down payment in a bank account or does this money need to be invested?
These are all critical questions that many first time home buyers ask. This post will provide a simple answer to this question.
Save for a house down payment using a high-yield savings account
The short and simple answer is that you should save money for a house using a high-yield savings account, such as those provided by the online bank, Ally Bank. Ally is the online bank that I used to save money when I bought my first house. My favorite feature of Ally and the reason I recommend them is that they offer unlimited savings accounts that can be easily and quickly set up for each of your individual savings goals.
Key benefits of using a Savings Account to save money for a house down payment
A segregated high-yield savings account offers the following key benefits when saving for a house downpayment.
- Maximum safety of capital
- Deposits in savings accounts are insured by the United States Federal government agency the FDIC.
- The nominal value of a savings account can’t decline due to market volatility.
- Focused tracking of progress towards your savings goal
- With a segregated account you can name the account “House Downpayment” eliminating accidental or unintentional spending of money you intend to save.
- Earn a small return on your savings (Secondary benefit)
- High-yield savings accounts will earn you a small return on your savings.
- The investment return should not be your primary focus because you are saving for a specific goal with a short time frame.
Alternatives and Counter-points
It is important for me to recognize that no answer is one-size fits all. Everyone is unique and situations vary. That is why I will touch on a few of the major alternatives that are usually considered.
Below I consider the following alternatives to a savings account:
- Should I invest my house savings in the stock market?
- Individual Development Accounts
- Certificates of Deposit
- Treasury Direct
Should I invest my house savings in the stock market?
Short answer: No.
The reason is quite simple. The purchase of a house has two key characteristics:
- Limited time horizon (Usually within the next 1-5 years)
- Need for a specific large sum of money
When you are saving for a large house down-payment you usually have some idea of the amount of money you need. The typical recommendation is to make a down payment of 20% of the house purchase price. This means a saver would need $40,000 for a down-payment on a $200,000 home.
Characteristics of stock market investments
On the other hand, investing in the stock market has the opposite characteristics a saver would look for:
- Stock market investments are best for long-term time horizons (greater than 10 years)
- Uncertain and unpredictable returns
- No guarantee or safety of capital
Therefore, the only time to consider investing money that you intend to use for a house down payment is when the house purchase is at least 10 years in the future. 10 years is long enough that the short-term volatility of the stock market is unlikely to result in loss of capital.
Alternative #1: Individual Development Accounts
The best alternative for first-time house buyers is what is known as an individual development account. These accounts are also known as matched savings programs.
Individual development accounts are state and federal programs designed to encourage low-income households to save money for a house down payments. Eligibility and program terms vary by state and these programs are generally offered by local nonprofit organizations. However, they mostly function in the following manner:
- A low-income individual requests an individual development account for an eligible expense, such as a home purchase.
- After approval, the individual agrees to save a specific amount, such as $2,000 over a given period of time. For instance, over the next 12 months.
- The non-profit organization matches every dollar that the individual manages to save. This is usually at a high rate such as 2:1 or 3:1.
Example: Savings of $2,000 matched 3:1 in an individual development account
- Individual saves = $2,000
- Non-Profit matches = $6,000
- Total Savings = $8,000
This method of savings allows a low-income household to receive a 300% return on their savings without taking the risk of investing in the stock market.
Alternative 2: Certificates of Deposit
Certificates of deposit, or CD, are made with a financial institution. Most banks offer them. A CD tends to offer higher rates of return than savings accounts in exchange for lower safety.
Certificates of deposit are not FDIC insured which is the primary reason that I discourage using them to save for a house down payment. In addition, they offer less flexibility on withdrawal timing than a savings account.
Alternative 3: United States T-Bills using Treasury Direct
Treasury Direct is a United States federal government website that allows individuals to buy savings bills and bonds directly from the government. Treasury Direct offers the benefit of government safety combined with the benefit of higher rates of return than savings accounts.
The only drawback with using Treasury Direct is the loss of flexibility on the timing of withdrawals. This makes Treasury Direct a better option than certificates of deposit, but still worse options than savings accounts. However, it is possible that individuals needing to save large sums of money that exceed FDIC insurance limits could benefit from making Treasury Direct their primary savings vehicle.