Dear Dr. Don,
Where is the best place to invest money earmarked for a home purchase? I plan to save for about three to four years, and I plan to put away $1,000 per month. I believe the time period is too long to just have the money sit in a savings account earning 1 percent, but the time period is also too short to invest in volatile stocks. So where is the middle ground? Bonds? I'm not looking to make a killing in interest; I would be happy with something like 2 percent to 4 percent.
-- Devin Down payment
By your projections, you'll have somewhere between $36,000 and $48,000 saved for the purchase of your new home. It's great that you can set aside that much per month toward this financial goal.
You've got a good handle on the risk and reward trade-offs when investing for an intermediate-term goal. You don't want to swing for the fences by investing in risky assets, taking a chance that you'll lose principal in the account.
The fear in investing in bonds is that interest rates will head higher and the prices of the bonds will decline. Yield and price have an inverse relationship. If yields go higher, bond prices decline. If yields go lower, bond prices increase. There's not a lot of room for interest rates to go lower, so price risk is a factor.
One way to finesse that risk is to invest in short-term bonds that mature around the time you expect to need the money. You'll be less concerned about the intermediate price fluctuations because, barring any default risk, you'll get the bond's face value at maturity. A CD portfolio is another alternative, but as your investment horizon gets shorter -- as with the bonds -- you're likely to get a lower yield.
I'd enjoy the challenge, but it will be an expensive nuisance to buy $1,000 worth of individual bonds each month, unless you're using the TreasuryDirect program to buy Treasury securities. Even then, you won't get the yields you're looking for in the Treasury market unless you buy TIPS and inflation ramps up. A short-term bond fund is a reasonable trade-off.
One thing to keep in the back of your mind is that you can be penny wise and pound foolish when it comes to waiting to buy until you've saved up a large down payment. I'm not encouraging you to buy a house on a hope and a prayer that you can afford it, but odds are that home prices and interest rates are at or near cycle lows. Waiting three to four years to buy may have you spending much more on your home and financing it at a higher interest rate.
Consider a Federal Housing Administration mortgage with lower down-payment requirements that may allow you to buy a home in the next one to two years. The "FHA Frequently Asked Questions" page on the Department of Housing and Urban Development website will give you an overview of this type of mortgage loan.
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