Investing the Down Payment
As with all informed investing decisions, which investment(s) you consider for money earmarked for your down payment should be determined by how soon you'll need the money back. The longer the time frame during which you can invest, the more growth-oriented and riskier (that is, more volatile) an investment you may consider.
When the stock market is rising, as it has done so often in recent decades, you may be tempted to keep your down payment money in stocks. After all, when you're getting returns of 20 percent or more annually, you'll reach your down payment savings goal far more quickly. Stocks are a generally inappropriate investment for down-payment money you expect to tap within the next five years. More aggressive individual stocks should have even a longer time horizon -- ideally seven to ten or more years.
Investments for five years or less
Most prospective homebuyers aren't in a position to take many risks with their down-payment money. Although it may appear boring, the first (and likely best) place for accumulating your down-payment money is in a money market mutual fund. As with bank savings accounts, money market mutual funds do not put your principal at risk -- the value of your original investment (principal) doesn't fluctuate.
Money market funds are one of the three major types of mutual funds -- the other two being those that focus on bonds (bond funds) and those that focus on stocks (stock or equity funds). Many people think of mutual funds as being risky investments, partly because they equate funds with stock market investing.
Although some bank savings accounts pay reasonable interest rates, nearly all pay less in interest than the best money market funds. If you really want to save through a bank, shop, shop, shop around. Smaller savings-and-loans and credit unions tend to offer more competitive yields than do the larger banks that spend gobs on advertising and have branches on nearly every corner.
In addition to higher yields, the best money market funds offer check writing (so that you can easily access your money) and come in tax-free versions. If you're in a higher income tax bracket, a tax-free money market fund may allow you to earn a higher effective yield than a money fund that pays taxable interest.
The better money market funds also offer telephone exchange and redemption and automated, electronic exchange services with your bank account. Automatic investment comes in handy for accumulating your down payment for a home purchase. Once per month, for example, you can have money zapped from your bank account into your money market fund.
Investments for more than five years
Should you expect to hold onto your home down-payment money for more than five years, you can comfortably consider riskier investments, such as longer-term bonds as well as more conservative stocks.
Short-term bonds and bond funds
Whenever you invest in bonds that won't mature soon, you are taking on risk. First is the risk that the bond issuer may fall into financial trouble between the time that you buy the bond and the time that it is due to mature. Second is the risk that interest rates in general could greatly increase. If the latter happens, caused more than likely by unexpected inflation, you may end up holding a bond that pays you less interest than the rate of inflation.
Most of the time, bonds that mature in a few years should produce a slightly higher rate of return for you than a money market or savings account. However, if you invest in such bonds, recognize that you may end up earning the same (or perhaps even less) than you would have earned had you stuck with a money market fund. Rising interest rates can deflate the value of an investment in bonds.
Invest in bonds only if you expect to hold them for at least three to five years. If you want to invest in individual bonds and you're not in a high-tax bracket, consider Treasury bonds, which don't require monitoring of credit risk. Also look at the yield on bank certificates of deposit. You may also consider some high-quality, short-term bond mutual funds that invest in -- you guessed it -- short-term bonds.