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Where to save for that down payment

FinancingDear Dr. Don,
I want to save for a down payment for a house in two to three years. I am planning on saving $200 a month. What is the best investment for this given the shaky economy?
Thanks,
Lesli Leverage

Saving for a down payment

Dear Dr. Don,
I am looking to either save or invest money so that in the next couple of years I could use it for a house. As of right now, what is the best thing to do as far as savings/CDs, etc.?
Thanks,
Dale Downpayment

Dear Lesli & Dale,
You shouldn't take on much risk when investing for a short-term goal such as a house down payment. Contributions to the account mean much more than the actual interest earned over such a short investment horizon, as shown in the table below:

Interest earned over a short investment horizon     

Interest earned:

2%

5%

8%

-15.5%

Monthly savings:

 $200

 $200

 $200

 $200

Months saved:

36

36

36

36

Ending balance:

 $7,414

 $7,751

 $8,107

 $5,787

Difference:

 

 $337

 $693

 $1,627

Months to recoup difference when investing at 2%:

 

1.68

3.47

-8.13

Nobody invests planning to lose an average 15.5 percent on their investments, but that's what an investment in the Standard & Poor's 500 did from 2000 through 2002. While it's unlikely that the stock market will continue its losing streak over the next three years, the point is that it's not worth taking the chance that it will when investing for a short-term goal.

 

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If you've already started to accumulate a down payment, an aggressive approach would be to use FHA financing to buy a home today with 3 percent to 5 percent down, capture the current lows in interest rates, and hope that the real estate market in your community isn't a bubble waiting to burst if mortgage rates climb higher. The FHA library can fill you in on this method of mortgage financing, including lending limits for FHA loans in your community.

The example below shows a situation where housing prices stay flat, but interest rates rise over the next three years. You dutifully save your $200 a month at 2 percent and have an additional down payment of $7,414. Not only is your payment $155 a month higher than you might get in today's market, but you'll pay an extra $63,000 in interest expense over the life of your loan -- even with the lower loan amount.

Stagnant home prices with rising interest rates   
 

Buy today

Buy in 3 years

Difference

Market value:

 $159,687

 $159,687

 

Loan amount:

 $154,896

 $147,482

 $(7,414)

Interest rate:

6.5%

8.5%

 

Loan term (months):

360

360

 

Payment:

 $979

 $1,134

 $155

Total payments:

 $352,457

 $408,243

 

Total interest expense:

 $197,561

 $260,761

 $63,200

I'll be the first to tell you that I don't know where interest rates will be three months from now, much less three years from now. What I'm hoping to illustrate with these two examples is that you don't need to chase return when investing for a short-term financial goal and that rising interest rates might make you wish that you bought today.

-- Posted: July 1, 2003

 

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