Where Should You Invest the Cash For Your Next Down Payment?

by | BiggerPockets.com

It’s a common question from folks saving up to buy their first (or next) rental property, house-hack, or primary residence:

Should I keep my money safe in a checking account?

Or, should I somehow invest this money so that I can earn a return in the meantime?

This blog post will give you the tools you need to make the right decision for you.

And let me start off by saying that I’ve been there. I’ve been the guy who’s hungry to get started. The guy who is hustling and grinding, month in and month out, to save at first $1,000, then $1,200, then $1,500 per month. You rack up your first $4,000, then your first $7,000, then $10,000. And still, after months (or years) of saving, it’s not quite enough to comfortably purchase an investment property or a home in your area.

It’s slow, it’s painful, and it’s infuriating.

You’re anxious to get started investing, making your money work for you, and ready to begin accelerating towards financial freedom.

I get it.

The answer can’t be to just sit tight and stockpile cash — tens of thousands of dollars in cash — in a bank account while preparing to buy that first (or next) property, can it?

It’s not.

The correct way to stash cash while saving for a down payment is different for everyone and depends upon circumstance, the length of time for which you intend to invest, and your tolerance for risk and reward.

But, I will preface this post by saying that very few people invest their way to a meaningful down payment. The fact of the matter is, this discussion really only exists for someone who is capable of saving systematically toward the next down payment. If you are unable (or unwilling) to save, and have only a small amount of cash to begin with, this discussion will be largely meaningless to you. If you’re unable or unwilling to steadily and aggressively accumulate wealth, you need to find a way to create enough value to purchase a property, or find a great deal and finance with other people’s money.

That said, let’s talk about the differing philosophies behind how to approach saving for the next down payment. We’ll dive into why certain options may be better than others for different folks, and then I’ll explain my personal approach to saving. Then it will be up to you, of course, to decide what to do with your cash.

The three Philosophies for storing cash while saving up for a down payment are as follows:

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1. Keep the cash as safe, accessible, and insured as practical

Keeping cash accessible, safe, and insured against loss almost always means storing it in the bank. In today’s world, it’s probably safer to keep money in the bank than to keep it anywhere else. It’s insured by the Federal Reserve. It’s accessible instantly via wire transfer, debit card, or a bank visit. And you aren’t going to lose big on an investment that goes south if your money is parked safely in the bank.

Pros: flexibility and the ability to multipurpose the money

As I grow my real estate business, my expenses and potential need for cash continuously grow. I have separate bank accounts for each of my properties, and I keep a large reserve in them to protect myself from the inevitable months in which I have to spend tens of thousands of dollars fixing a roof, replacing a bathroom, turning over a unit, etc. — or potentially doing all of that at once.

I’m much less likely to incur these types of large expenses in my personal life than in my business, so I keep an additional, smaller reserve, for personal needs.

At first, when I was building up my savings, all the money was jumbled together. I didn’t have any property, and so why would I set aside money for a down payment? I just built up ALL my cash in the same bank account. This cash wasn’t necessarily just for a down payment on my first property, it was also my emergency reserve — my financial runway. It gave me options, not just for a down payment, but also the ability to survive (at first months, then years) without needing a traditional job.

This flexibility, and simply having a large cash reserve, brings an incredible peace of mind. Perhaps even more importantly, it exposes you to opportunities. Meaning, if you are looking for them, you might be able to spot investment opportunities to exploit thanks to your favorable cash stockpile. These deals won’t be available to investors without ready funds.

Cons: 0% interest on your savings at most

Your money is losing value to inflation with every passing month. If you do not deploy it, you are almost surely losing slowly. This disadvantage compounds as your stockpile grows. Earning a 0% return on the first $3,000, $5,000, or $10,000 is very different from earning a 0% return on $100,000, $250,000, or $1,000,000.

Related: Where Do You Get the Money for Your First Down Payment?

2. Seek a modest — but relatively safe — rate of return

Pros: earning rather than losing

This is a popular philosophy among investors who are careful planners but have a pretty rigid budget. If you can accurately plan out when you will need the money, and are willing to forgo some flexibility in terms of how readily accessible your funds are, you may be able to eke out 1%–4% returns on your cash. CDs, money market accounts, treasury bonds, and the like, all offer very modest returns that are unlikely to drop in a way that will materially impact your goals. Proponents of this approach will argue that “earning something is better than nothing,” and they are absolutely correct.

Cons: limited returns

The disadvantage to this approach is mediocracy of your returns. You’ll ensure that you earn modest returns in the months and years leading up to your first purchase, but those earnings will amount to an extremely small amount of money. If you are saving up for your first down payment, and need $50,000 to do so, with a conservative approach you’ll earn (at best) around $500–$2,000 per year. This money is not going to make a big difference in your day, but, again, it’s certainly better than nothing.

3. Seek The Greatest Semi-Liquid Return Available

It’s no secret that many of the greatest returns can be generated from illiquid investments — investments that you can’t easily sell. (Think real estate, small businesses, startups, websites, etc.) While it’s possible to sell some of these assets quickly, often doing so in haste results in losses for the seller. That’s why it probably, in most cases, makes sense to invest in assets that can be sold within hours or days. Think about a money market account. Within hours, funds can be transferred out of a money market account and into a bank account.

Pros: high Returns

In all likelihood, for the majority of folks, the highest potential returns from semi-liquid investments will come from publicly traded securities like stocks, funds, ETFs, and REITs. Publicly traded securities can be sold during regular hours on most business days, and the proceeds can be transferred to your bank account. You’ll be ready to buy real estate in about a week.

So, it is very realistic to simply take your cash and invest it in the stock market, or other publicly traded securities, and then sell off those assets when you are ready to buy real estate.

The advantage to this is that you expose your money to asset classes that historically produce much higher returns than checking or savings accounts. The data set from NYU’s Stern School of Business shows a total compounded return of just under 10% over the long run from an investment in the S&P 500, for example.

Cons: higher risk

The disadvantage is that public markets are much more volatile than more conservative investments like the savings and checking accounts mentioned above. This means that there is a very good chance that employing this strategy in the long run will result in a very bad year at some point. It means that a significant percentage of your savings may get wiped out, potentially delaying your plans to invest in real estate. You will lose if you employ this strategy over the long run — most likely multiple times.

Related: The Foolproof Monthly Budget: How to Save Up Money to Buy Investment Properties

My Strategy of Choice

I employ option number 3. I keep cash reserves in the bank for my personal expenses and for my real estate business. But for the past four to five years, I’ve invested all the money for my next real estate project in the stock market, almost entirely in index funds. I absolutely understand the risks and downsides that come with keeping my money in the market. I am aware that the market may come crashing down some day. In fact, I’ve been told that for years.

However, I trust my system, and I trust history. Even though I know I will lose occasionally over the next years or decades, I trust that over time, I will achieve close to the stock market’s historical return (8%–10%) on my invested assets. I trust that my gains will significantly outweigh my losses.

This is my choice. So far I have benefitted greatly from this approach. The past few years have been friendly to investors with holdings in the market. I am fully aware that at some point I will face consequences from my approach, perhaps shortly. But, as I am not smart enough to time the market, I will trust my system. Maybe I’ll have another great year and be able to buy more real estate than planned. Maybe the market will collapse and I’ll be set back months or even a year. But, over time, I believe that the math will be on my side.

Conclusion

What’s the right approach for you? Perhaps you think that my approach is foolish or dangerous. Perhaps you find it has merit. I don’t know what the right answer is for sure. But, I wanted to share my theory with the community to generate a discussion and feedback.

There is no one right way. My circumstances may be very different from yours. I have already established several properties and a large emergency fund. I have great insurance and healthcare through my employer. If I suffered a surprise bankruptcy, I suspect that my parents would let me move back into their basement while I straightened things out. These safety nets enable me to take more risks and be more aggressive than the folks with families who want more flexibility and value conservative investing in case they need to bail out the family from an emergency.

Are you more conservative with saving for you next down payment — or are you more aggressive, like me?

Are you in the middle, like many investors? I want to hear from you!

 

 

 

About Author

Scott Trench

VP of Operations at BiggerPockets.com, Scott is also a licensed real estate broker/agent, real estate investor managing 8 units in Denver, CO with a partner, a house-hacker, and personal finance nerd. His book, "Set for Life" (published through BiggerPockets Publishing) thoroughly details a step-by-step journey to early financial freedom for full-time workers earning median incomes and starting with little or negative net worth. When he's not helping full-time workers move toward early financial freedom, the 26-year-old can be found playing rugby, biking, or skiing.

37 Comments

    • Scott Trench

      I formerly used Scottrade, but I have transitioned to using the Robinhood App – I buy Vanguard ETFs, and Robinhood processes the trade for free – $0. I also need to do more research and consider Wealthfront and/or Betterment. I’ve heard good things.

        • Scott Trench

          Interesting debate! I actually threw a little bit of money into one of these companies recently to try it out. I see both sides of this argument, but feel that it is a good experiment. On the one hand, there is a lot of great diversification and many options for allocations. On the other hand, I as the investor am very far removed from the underlying securities, which creates a knowledge gap and perhaps a false sense of security.

      • Akilan Narayanaswamy

        +1 for Robinhood. Can’t beat free. Roboadvisors really only have the benefit of tax-loss harvesting but it only really helps extremely high earners because of their higher marginal tax rate. I personally enjoy being able to choose my own investments but that’s just me.

      • Jim S.

        I’ve used Wealthfront in the past + Betterment now. Both are great services, this is where I keep my money for future purchases.

        Allows for tax harvesting short-term losses which is great from a tax perspective (goes against income if no excess capital gains). You can set whatever level of risk you’d like, personally I like to keep my RE money 60% stock 40% bonds in case of a short term downturn, if it were just a long term investment I’d do near 90/10 or 100% stock.

  1. Edward C.

    Agree with the alternatives and (given the low interest rate environment and correspondingly low “safe” options to earn a decent return on otherwise idle cash) I also choose a variation of option 3. I think the key is to be aware of market sentiment.

    I’m not advocating market timing (difficult), but if it really is money that doesn’t have to be deployed in the near term, I PERSONALLY am comfortable with the risk/reward of parking my money in equities. At the end of the day, agree with you that it really is a personal choice.

    We’ve generally benefited from a rising equity (and RE!) market for the past couple of years, so my perspective may change. For now, since I’m not betting the farm on equity appreciation for cash set aside for RE, it’s an acceptable alternative for me.

  2. Jim S.

    My normal flow of cash from my job is as follows:

    Paycheck goes directly into my Discover savings account (earns 1%/yr, better than a checking account if you can keep under 6 withdrawals per month).

    Living expenses (rent, credit cards, etc.) for the month will be transferred to a separate checking account to be paid out.

    Anything leftover aside from keeping $1k in the bank as reserves will go into my Betterment account. Fairly conservative @ 65% stock, 35% bonds (mostly muni) – funds for downpayments are withdrawn once an offer has been accepted + inspection went fine.

    This should net about a 6% return on average with great diversification and in the case of a downturn I’m getting the benefits of daily tax loss harvesting to help write down my tax bill at the end of the year.

  3. Darin Anderson

    An option that was not discussed was to use a HELOC on a primary residence or an Equity Line of Credit on a rental property. I have several of these that I pull from and then pay back down.

    If one does not have enough cash to have a free an clear line of credit but you have enough for a down payment on a property then an option would be to work with a banker to setup a equity line of credit on one of your existing rental properties by paying the 20K+ downpayment that you have into one of your existing mortgages and then getting the bank to give you an equity line of credit for that same amount as a second mortgage / Line of Credit. If the property has increased in value they might be able to give you an equity line of credit for considerably more than that.

    Then you draw on that line and make your down payment on your new property. New funds go to pay down that line of credit until you have enough free credit there to make another down payment at which point you draw the money back out on the line and purchase the next property. Rinse and repeat. The nice feature of this is that it gets you a guaranteed return on your money of around 4-6% depending on the interest rates you are able to achieve and you never have to worry about getting caught with the market leaning against you at the time you need the money.

    • Scott Trench

      This is definitely an option – if you have a property that has equity in it already. If you are saving up for your first down payment, or are unable to get a heloc because you don’t quite have enough home equity, you might need to save up and/or invest in order to get that down payment.

    • Scott Trench

      I put my money into the stock market even when I contemplate using it sooner – I accept that volatility will hammer my reserve at a few points in my life and that I will absolutely lose. But, I believe that over time, I will reap the advantages of keeping my money deployed in a historically high return asset class, and that the average of decades of pursuing this strategy will be to my benefit.

      Certainly there are many smart people who would disagree with this approach though!

  4. Rick Grubbs

    Use an equity line of credit, such as home equity or an equity line on one of your properties as your liquidity to buy rentals and then refinance them. This way you can take any excess cash and pay down the equity line but still have the money available. My commercial line is at about 6%, so whenever I pay extra down on it I am making 6% with zero risk! I don’t know another fund that promises that.

    • Mike Redick

      I’m starting to do something similar but… I don’t see how you get a return? You’re paying interest on the money you borrow from the HELOC. It seems like losing cash in order to buy more properties faster, rather than getting a return.

      • Darin Anderson

        The HELOC is in lieu of a similar mortgage on that property (either first or second). So rather than having that portion in a mortgage you have it in a HELOC or ELOC. Then when you are accumulating capital rather than sit on it or put it in the stock market you pay down your HELOC until you get enough to make a down payment. Then you draw it out again, make the down payment and start the cycle over. See my comment above for how you could get started if you have a mortgage and cash and want to have a HELOC instead.

  5. Christopher Giannino

    Loved the article, Scott! I’m a newbie investor just venturing into my first REI deal but I used Strategy 3 to catapult my savings. When I first started investing in the stock market, I would pick individual large cap growth stocks. I “won” (really just got lucky since its a bull market) with many of my picks but I did lose money as well. As you said, if you employ this strategy be prepared to lose some money because eventually it WILL happen. Recently, I started transitioning my stock portfolio to EFTs with very low expenses instead of picking individual stocks. EFTs are more diversified due to the many different company stocks being held by the EFT and overall generate similar returns. Ultimately, I feel like EFTs are a more passive approach to investing in the stock market.

  6. Joe Ranch

    It all depends on your time frame. The rule of thumb is to not invest in market equities (stocks, EFTs, mutual funds) unless you have at least a 5 year outlook. There is another option I use for 2-5 year money, short term bond funds.

    These normally return 3-5%, dividends and appreciation, with very little market risk. USAA, Fidelity, Vanguard, etc…all have very good short and Ultra short term bond funds that they will let you buy and sell for free if you have an account with them. It is almost like a savings account that that returns 3-5%, as you can deposit and withdrawal as many times as you want for free.

    To quantify the minimal market risk, had you owned USAA’s short term fund USSBX in 2008 you would have lost 10% and gained it back in about a year…

  7. Eric Jones

    I typically use Option 3 as well… However, I typically focus on closed end funds due to their income characteristics… many pay out monthly distributions in the 7-10% range. I then have distributions automatically reinvested for maximum investment efficiency and compounding. By reinvesting distributions, you end up accumulating a lot of additional shares, which serves as a nice cushion to protect you from downside risk.

    • Scott Trench

      Jesse – I have not spent time researching and becoming confident in the cryptocurrency markets, as I focus on real estate investing. It’s possible that I change that down the line and put in the time to try to become an expert, but for now I stay away simply because I am unfamiliar with it and do not believe I have any competitive advantage there.

  8. Justin Colletti

    While it is wise to seek a return on your down payment funds, there is a big problem with US stock index fund for the purpose of holding you down payment. Specifically:

    US stock prices tend to be positively correlated with US real estate prices. This means that JUST when U.S. real estate prices start coming down to attractive levels compared to rents, the purchasing power of your down payment will be cut in 1/3, 1/2 or more, at the same exact time.

    (Whether this happens by a price drop, like in the last crisis, or through inflation, like in the 1970s the hugely negative effect on your purchasing power is essentially the same.)

    This happens in most business cycles if you were to have just thrown your down payment money into an index: JUST when you will want your money for a down payment most, your purchasing power will be slashed. Not ideal.

    Better yet, try storing your funds (or at least a good portion of them) in things that are uncorrelated or, better yet, *negatively* correlated with real estate prices.

    Precious metals and other commodities, for instance, are often either barely or negatively correlated with real estate over long stretches. In recent years, foreign stocks have moved in very different cycles from US real estate as well.

    Pursuing such a strategy makes it so that when real estate prices are finally becoming attractive compared to rents, you will be able to buy MORE real estate, rather than less, which is what would ordinarily happen with the strategy mentioned here.

    Even if you don’t want to pursue this strategy whole-hog, it is sensible to put at least a portion of your liquid assets for a down payment into commodities, resource stocks, precious metals, foreign stocks, and the like.

    One popular approach here is the “Permanent Portfolio”, which is essentially comprised of:

    25% precious metals/commodities. This is usually done with an emphasis on gold because of its inverse correlation to other asset classes. (Though strategies differ)

    25% in stocks. A healthy portion of this should be in foreign market indexes. (Preferably the lowest priced markets by CAPE to minimize your downside and maximize your upside)

    25% in cash and cash equivalents, such as short term treasuries. This is for liquidity and limited downside in case the turning of the next credit cycle is deflationary rather than inflationary. (Which seems somewhat unlikely at this time, but who knows?) And finally:

    25% in bonds or fixed income. (Though, be careful of developed world markets at this time, where real interest rates may be effectively negative!)

    This strategy has a very good track record, basically comparable with the returns of the S&P 500, but with far less volatility and less short-term downside risk at exactly those times you’d prefer to actually USE your down payment to scoop up great real estate deals.

    A strategy like this one may require some adjustment based on current conditions. (For instance, I do something similar, but have pretty much no long term bonds at today’s rates, I favor silver slightly over gold for the commodity portion because it is even more undervalued, and I have practically $0 in US indexes because of how overpriced they are compared to other indexes.)

    But in general, this kind of approach is proven to have similar returns to the US stock indexes, but with far less chance of a hugely down year. It is worth the consideration of any real estate investor.

    Hope this helps!

    • gil flmeinga

      Justin

      Thank you for your comments. This was just what I wanted to hear.

      I particularly agree that us indexes are at a frothy peak. I cashed out 50% of my us index portfolio in Octber.

      Did you hear me correctly? In October before the Trump bump!

      Question: I want to take $4,000 and invest it until I have enought for a down payment. I want to put $1.000 a monthl into precious metals.

      $2.000 per month into Vanguard short term corp bonds, getting a 2% yield

      $1k? Where should this go?

      • Justin Colletti

        Hi Gil,

        Great questions! And don’t feel too bad about selling. If you sold out of the NASDAQ in 1997 or 1998 you would have looked crazy for a year or two, after having cashed in on your huge returns. But others would have looked at you funny as the paper returns kept on growing and growing…. Until the NASDAQ crashed by about 80% shortly thereafter, wiping out anyone who used this strategy for saving for a down payment.

        I’m slightly wary of US corporate bonds at the moment, because the interest rates are barely higher than their treasury equivalents, and unlike with government bonds, they can actually have a “hard” default in case of a deflationary turn, so you have risks going both ways:

        1) In an inflationary turn, their interest rates could be effectively negative, losing you purchasing power

        2) In a deflationary turn, they could have a hard default and you can lose nominal value and purchasing power

        Usually, this risk is offset by them paying considerably higher interest rates than equivalent treasuries, but that just isn’t the case at the moment. With treasuries, you only have the inflationary risk, but not the deflationary risk. (The government can always just “print” the money, so you never lose nominally. You only lose purchasing power 🙂

        I can’t tell you what to do, but I can tell you what I am doing. My modification of the Permanent Portfolio strategy to deal with current market conditions is to split my portfolio in thirds:

        1/3 Stock indexes, focused on fairly and cheaply-priced foreign stock indexes.

        (Here’s a great resource for finding some of the most fairly priced stock indexes in the world: http://www.starcapital.de/research/stockmarketvaluation I also have some articles about it myself: http://justincolletti.com/2016/03/10/how-to-tell-when-stocks-are-overpriced-its-easier-than-you-may-think/ )

        1/3 Precious metals, other commodities and select resource stocks.

        (Gold and silver mining companies are selling for a very low ratio to their respective commodity prices at the moment. I’ve had tremendous gains in these since buying near the bottom toward the end of 2015, and expect much more to come. Gold is about fairly priced due to nervousness about the current credit cycle, but silver and many other commodities are very low compared to historical norms.)

        1/3 in Cash or Cash Equivalents

        (Such as short-term Treasuries. 2 year, 3 year, Maybe a little bit of 10 year.)

        That said, my big gains in foreign stocks and metals over the past couple years have made it so I’m getting dangerously close to 40/40/20, and it’s probably about time I rebalance!

        Of course, this breakdown doesn’t count any of my modest investment property. Once you throw that in, it’s probably more like 25/25/25/25 when I rebalance. Incidentally, that’s pretty much the strategy that legendary investor Marc Faber takes in his modified version of the permanent portfolio.

        He’s roughly split evenly across:

        25% precious metals (I don’t think he holds much of other commodities)
        25% fairly priced stocks (mostly foreign),
        25% cash/cash equivalents and bonds (spread across currencies for the cash portion and mostly emerging market debt with higher yields and relatively low risk for the debt portion) and
        25% fairly-priced real estate (again, mostly foreign and emerging markets for him, but there are fair deals in some markets in the US).

        There are a lot of ways to set up a truly diversified portfolio, but the basic idea is that if your goal is to purchase real estate with these funds, you want to focus just as much on preserving your real purchasing power as you want to focus on getting a healthy return.

        Some variation of the permanent portfolio strategy that makes sense to you is a fairly good bet for doing just that.

    • Scott Trench

      These are great debates. I actually agree largely with your premise. But, I also believe that I have no idea when the crash is coming, and I believe that by staying invested, assuming that I have no ability to predict market crashes, that yes, the down years will be large and hard, but that the up years will more than make up for that loss. Just my personal preference.

  9. Charlie Chung

    I would use Wealthfront or Betterment, and for short-term use, I’d set the risk level lower, which dials up the bond portion of the portfolio.

    A slight caution is that they can take a little longer to liquidate & transfer than traditional brokerages.

  10. Andrew Allen

    One downside to CDs that you didn’t mention is that they’re not very liquid. Most CDs are for a particular term. If you have a 12-month CD but need the money in 6 months you’ll pay a penalty to get that money out…and you have to cash the entire amount out at once. Ally Bank has an 11-month CD that has no cash out penalty but that’s the only bank I’m aware of that does that, and you still have to cash out the entire amount if you need the money.

  11. Dustin schrag

    Great Post! I have actually been saving like a mad man this year to save up 25% down for my 3rd property this year. I have been putting my money in a vangaurd VTSMX fund. This is my first time using this strategy and am wondering if there are going to be any taxes when i pull the money out of an index fund to put into a rental property? Sorry if its a dumb question.. just excited to buy my next property and wanted to cross my t’s and dot my i’s.

  12. Jeremy Barth

    You’re practically doubling the taxes on your gains if you sell in less than a year. If you push/pull money a lot to fund deals, it seems like your effective return is going to be much lower than the historical 8-10% stock market returns.

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