Own a Home but Looking to Move? How to Save for the Next Down Payment

A down payment for a house can be one of, if not, the largest single expenses in a person’s life.  It’s no wonder many choose to rent instead of purchase.  However, if you are like us here in the Heartland on FIRE household, you may be addicted to real estate and home ownership may be a very important goal for you.  We figure we have one or two more houses in us yet.  As with all goals, a well thought out and soundly executed plan is key to achieve your objective.  The problem is, there are several options to consider.  So let’s take a few minutes and run down some of them to see what may be the best option.

First off, why are we even talking about buying a house?

We’ve been in this house 3 years this month.  We like our current house a lot.  We really do.  It works well for our current situation with two little ones.  But… we do not plan to retire in this house.  The desirable features for the next house include a bigger, better lot and will probably have less square footage, but on a single level as opposed to our current two-story.  A nice ranch on a big lot. That’s what I am thinking.

To be very clear, this is a want, not a need.  But we REALLY want it.

What’s our timeline?

Our best guess is 8 to 10 years.  By this time our daughters will be in middle school.  This is significant because the middle school includes more area within its boundaries than the elementary school; therefore, we have more housing options.  This includes a few neighborhoods we specifically have our eye on.

Sorting through the Options

Savings Account

I am including high-interest online savings accounts and money market accounts here.  This is pretty straightforward.  Deposit your money in the bank account and there it (mostly) sits until you are ready for it.  Interest ranges from almost zero at big banks to around 2% currently for some online options.  These accounts are Federal Deposit Insurance Corporation (FDIC) insured so there is essentially zero risk of a loss.

Or is there.  Inflation varies, but generally averages 2% per year.  If the savings account interest rate is lower inflation (a strong possibility) then we would be guaranteed to lose purchasing power!

Certificates of Deposit

When you purchase a Certificate of Deposit (CD), you lend a bank your money for a set period of time.  In return, the bank pays you interest.  Current rates are on par with the higher end of online savings accounts, approximately 2%.  CDs are FDIC insured so the risk of loss is negligible, provided the return is at least equal to inflation.  Negatively, your money is tied up until the CD matures and returns are lower than other options discussed below.

Bonds

With a bond, you are lending a government or corporation your money.  In return, they pay you interest.  Additionally, you may be able to sell the bonds at a higher price down the road.  The potential return with bonds is typically better than with savings accounts.  The risk is more than savings accounts, as the bond issuer could default; however, some options (US Treasury bonds for example) are very low risk.  The risk is substantially less than stocks. You can also buy bond funds, which hold multiple bonds, to further diversify away your risk.

Stocks

With stocks you buy shares of ownership in corporations.  The goal is to sell your shares when the prices are higher.  Additionally, many stock pay dividends out of their profits.  Stocks offer the prospect of higher returns than savings accounts or bonds (at least in recent times… this has not always been the case).  The risk associated with stocks is the highest of the options discussed so far, particularly if you put all your eggs in one nest (one company).  A single company can tank making your holdings worthless in short order.

This risk can be mitigated by spreading your capital over several companies, either individually, or through a mutual fund which holds various assemblages of companies.  Mutual funds are attractive to the lay person because they combine the benefits of spreading out your money and having fund managers research each company (as opposed to you).  On the flip side, someone has to pay these managers which results in fees that get passed along to you.  Also, some (most?) managers never consistently match the market’s performance as a whole, much less beat it.  Some of this is due to those pesky fees, some is due to bad management, and some of this is due to the randomness that is the stock market, which is outside their control.

To reduce the fees associated and the hit and miss nature that comes with active fund management, you could consider an index fund.  These passively managed funds track a specific index, like the S&P 500 and operate with minimal overhead.  Some hold every stock within an index, such as a Total Stock Market fund.  By holding every stock you don’t have to worry about picking winners and losers… you have them all.  This takes human nature out of the picture. ***steps off soap box***

Additionally, this risk is further reduced with time.  The market can drop in any given year, and a recession can take years to crawl out of; however, the longer you hold your shares the better the odds that the price will increase.    As an example, the average S&P 500 return over the last 90 years is roughly 10% before inflation (per Investopedia).  According to Morningstar, which looked at stock market returns from 1926 through 2017 the probability of a loss over a 5-year period was 14%.  Over a 15-year period, the probability of a loss dropped to essentially 0%.  Risk is relatively low within our 8 to 10-year timeframe.

Pay Down Our Current Mortgage

We have a house with a mortgage so we could choose to divert additional money towards paying down the balance; thereby, increasing our equity.  This increased equity could go towards a down payment.

A benefit to this approach is that the returns are easily calculated (they equal your current interest rate).  The downsides are that a housing recession could cut deeply into the value of your home, such as following the 2008 recession, and the equity is not available until you sell your house.  The significance of this is since your down payment money is tied into the equity of you current house, you may not be able to react quickly enough if your ideal house hits the market.

Increase Equity with a Live in Flip

Another option involving home equity would be to update or improve our current house to “force” appreciation.  This is a lot like house flipping, except that we are living here in the meantime.  When we bought this house we searched for a house that was in need of some updates, and priced accordingly.  This is crucial.  If the house was fully updated, then the opportunities to add value would be severely limited.  This house has several areas we can improve on, so the odds of some forced appreciation are good if we choose to go that route.

Beware though, care must be taken to make updates that prospective buyers will like.  So maybe hold off on painting that floor to ceiling mural in your family room, or putting shag carpeting on the walls.

Let’s see how these options might stack up:

• First, the assumptions:
  • Yearly contributions to the plan: $12,000
  • Timeline: 8 years
  • Savings Account Interest Rate: 0.5%
  • Average CD rate: 2%
  • Average Bond Return: 4%
  • Average Total Stock Market Index Fund Return: 7%
  • Mortgage Interest Rate: 4%
  • Average inflation: 2%

Year	Savings Account	CDs	Bond Fund	Stock Index Fund	Paying Down Mortgage
1	$12,000.00	$12,000.00	$12,000.00	$12,000.00	$12,000.00
2	$23,820.00	$24,000.00	$24,240.00	$24,600.00	$24,240.00
3	$35,462.70	$36,000.00	$36,724.80	$37,830.00	$36,724.80
4	$46,930.76	$48,000.00	$49,459.30	$51,721.50	$49,459.30
5	$58,226.80	$60,000.00	$62,448.48	$66,307.58	$62,448.48
6	$69,353.40	$72,000.00	$75,697.45	$81,622.95	$75,697.45
7	$80,313.10	$84,000.00	$89,211.40	$97,704.10	$89,211.40
8	$91,108.40	$96,000.00	$102,995.63	$114,589.31	$102,995.63
9	$101,741.77	$108,000.00	$117,055.54	$132,318.77	$117,055.54
10	$112,215.65	$120,000.00	$131,396.65	$150,934.71	$131,396.65

Takeaways

• First off, the savings account actually loses value due to inflation eating away at the purchasing power of our money.
• The CD option would essentially be a break even proposition.  In reality it could do a little better or worse than inflation, since available CD rates and actual inflation are variable.
• Based on my assumptions the bond and paying down the mortgage options are in a dead heat.  But I would give the nod here to paying down the mortgage because… let’s not forget about taxes.  If you’ve lived in your home for 2 of the last 5 years, then you can avoid paying taxes on the first $250,000 of profit.  If you are married and file jointly this amount doubles to $500,000 (here’s the IRS document that explains this).  Bonds and even stocks can’t touch this.
• Stocks look very attractive here, but don’t forget about those pesky taxes again.  Your gains will be taxed depending on how long you’ve held your shares.  If you hold your shares for more than 1 year, then the gains are taxed at the lower capital gains rate.  Sell in less than 1 year and they are taxed at your marginal tax rate.  This can make a big difference (perhaps more than 10% in taxes).  Factoring 15% capital gains tax on $30,934 of gains equates in $4,640 lost to taxes… narrowing the gap between paying down the mortgage to about $15,000.

via GIPHY

So what are WE going to do?

Well… maybe a few different things.

Primarily we are going to invest in a total stock market index fund.  Based on our time frame it is clear that there is a big cost to playing it too safe.  The power of compounding really starts to become significant around 5 years.  Additionally, we like the idea that these funds can be used for anything else should we see a better opportunity come along.

Since the purchase of a new house is really a luxury rather than a need, we can take a bit more risk.  If the value of our savings tanks, then perhaps it’s not a good time to be buying anyways?

As we get within a year or two of starting to seriously look for a house, we may divert the money towards paying down the mortgage.  This will help us steer clear of taking a big hit to our investments right before we need them.  Additionally, this will keep us from selling an investment in less than 1 year, triggering a sizable chunk of ordinary taxable income.  Finally, this will help us boost our equity at the time of the sale without increasing our tax exposure.

Lastly, we will continue to make selective updates to our current house to force some appreciation.  We previously gutted and reconstructed the kitchen.  Likely future renovation targets include the bathrooms.  As realtors say: “Kitchens and bathrooms sell houses.” Besides, we gotta live in this place for about a decade… might as well enjoy it while we are here!

So what do you all think?