Today’s article was inspired by a recent blog subscriber, Justin, who reached out with some questions regarding home down payments. Like myself, Justin is a potential first time home buyer who has been in the market for many months, and submitted and lost several offers. He was wondering how I’m handling losing money keeping all that cash on hand rather than adding it to the FIRE fund. Honestly, inflation eating away at my down payment is something I think about a lot, so thanks for the article idea, Justin!
We’re going to take a look at some of the classical economic theory framing how you should view your down payment funds, examine a “secret” investment that outperforms your savings account and cannot lose value but is not often mentioned in the context of saving for a down payment, and revisit the state of the housing market.
The most recent Consumer Price Index (CPI) release for the 12 month period ending February 2022 printed a 7.9% increase. Without getting too far into the debate of the validity of the CPI, I think every American consumer can agree from firsthand experience that inflation is moderately high right now, and our dollars are losing purchasing power more quickly than any time in recent memory. It just so happens that using the CPI as an inflation gauge, it’s been exactly 40 years since we have last seen levels this high.
Our down payments’ lost opportunity cost
Many of us have heard the catchphrase “cash is trash” before. If you’re looking to build or even maintain wealth over time this is often true — cash loses value over time to inflation. Inflation is negative compound interest, putting that magic little formula to work against you. What is the proper baseline to assess that opportunity cost against though?
The CPI is simply “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” This includes things such as food, vehicles, fuel, and medical care. So if you were going to spend your down payment money instead on this same basket of goods meant to represent the average urban American, then from February 2021–February 2022, you lost 7.9% of your purchasing power.
If you’re reading this blog, you’re probably a stock market investor like me, shooting for financial independence. I’ve previously made the case for why my favorite investment is the Vanguard Total World Stock Market Index Fund (VTWAX). Over the same February 2021–February 2022 period as our CPI print, my favorite index fund went from a value of $33.59 to $35.29. It also threw off 68 cents in dividends over that period, for a total return of 7.1%. An investor in this fund lost only 0.8% of their purchasing power relative to CPI over the period.
Finally we have perhaps the most appropriate baseline of all, exactly what our down payments are earmarked for — a home! Using the Case-Shiller Boston Home Price Index to dial down to my specific area, the most recent 12 months of data is the January 2021–January 2022 period, where this index of existing homes increased by 13.3%. Skyrocketing home values have destroyed even more of my down payment’s purchasing power than the worst CPI number in four decades.
Understanding time horizons and risk
An investment time horizon is how long you expect to hold a particular investment before needing to sell it and take your money back. This could be within days for someone actively bidding on homes and needing to deploy their down payment fund should they win an offer. Or it could be decades before you need to sell the shares you are purchasing for your retirement, perhaps even longer if you save more than you need and create generational wealth.
There are many ways to define risk in investing, but for our purposes we can say it is the likelihood of loss of value on our investment relative to the expected return over our time horizon. It is a level of uncertainty as to whether your money will be worth more or less when you need to spend it.
As you probably already know, cash in a savings account is generally regarded as low risk. Your money will always be sitting there when you need it, plus a small pittance in interest payments. Even if the bank goes out of business, your money is protected by insurance in most countries, such as the FDIC in the US. However, consider the long-term: money kept in a savings account is practically guaranteed to be rendered virtually worthless over the span of multiple decades due to inflation. Does this make savings accounts risky over the long-term? No, because you should not have expected anything else given the interminable historical trend of interest rates on savings accounts not keeping up with inflation, therefore this outcome was nearly certain.
On the other hand, consider the stock market. Generally investors in a diversified stock market index fund expect to capture an average 8–10% annual return over the long-term. However returns in any single year can be highly volatile. Over the past 100 years, the worst single-year return for the S&P 500 was -43%, and the best year posted a 54% gain. If you invest in the stock market for just five years or less, whatever you expect the return to be, chances are incredibly high that you will be wrong, and by a larger margin the shorter your time horizon becomes.
Learn to stop worrying and accept the sunk costs
A sunk cost is a cost that has been incurred and cannot be recovered.
For two years now I have been stacking up cash for a down payment on a home, and still do not have a house to show for it after several lost offers and a single won offer with structural and mold issues that caused us to walk away.
But there is nothing I can do about the fact that my down payment has been sitting there losing relative purchasing power with skyrocketing home values over the past two years. There’s no use wondering about the extra money I could have made had I invested my down payment into stocks as I saved it up, using the hindsight bias that stock market values have risen during our home search.
Since we have been actively trying to buy a home for the past two years, the rational decision at the time was to keep our down payment in a savings account, since we could have needed it at any time. Investing it in any asset class did not make sense, since we were not willing to potentially lose some of it and have our plans to buy a home delayed even further.
Going forward, given that we still want to buy a home in the near future, the optimal decision is still to continue saving our down payment in cash. According to classical economic theory, the sunk costs are irrelevant as they cannot be recovered. Therefore only current information on our time horizon and risk appetite should be considered.
Even amid high inflation, the age old advice still holds — if you’re shopping for a home or actively saving for one, a savings account is the best option for your down payment, with the exception of…
I Bonds: an infrequently discussed “secret” investment if you’re a year or more out from purchasing a home
An interesting question posed by Justin is if your strategy changes if you’re over a year from purchasing a home, either due to needing more time to save, dropping out of the market for a bit to sign a rental lease, or any other factor. And the answer is yes, the advice does change in one small way for US citizens or residents which I don’t often see discussed in the context of saving for a home!
Series I Savings Bonds! If you buy some before the end of April 2022, these are paying a 7.12% interest rate for the next six months, and (unlike other bonds) the present value can’t go down. That’s right, you cannot possibly lose money with this investment.
Sounds too good to be true? Well, there’s a few caveats to be aware of:
- Each individual may only purchase a maximum of $10,000 of electronic I Bonds per calendar year, and up to $5,000 in paper I Bonds using their Federal Tax Return.
- You are not able to sell I Bonds sooner than one year after purchase.
- If you sell before 5 years, you sacrifice the last 3 months of interest.
- The interest rate adjusts every 6 months, based on CPI inflation.
Even with these caveats, I Bonds are still a great option for a portion of your down payment if you have at least a year until you are going to buy a home. A couple could protect $20k–30k each year from inflation by purchasing I Bonds. Even accounting for the 3 month interest penalty, I Bonds with their yield based on CPI are nearly guaranteed to far outperform a savings account. My Ally “high yield savings” is paying a pathetic 0.5% right now.
If you’re planning several years in advance to save for a down payment, you could amass a pretty formidable stack of I Bonds!
Learn more and purchase electronic I Bonds at the official US government site TreasuryDirect!
The best solution to rising rates is to save faster and save smarter
Buying a house is a competition with other households in your local area. Everything is relative to the financial picture of the median home buyer (which is a higher income tier than the median earning household). Over the long run I firmly believe that if you can save and build wealth more quickly than the median home buyer in your local area, logically you cannot be priced out.
Our frustration with the housing market over the past couple years is primarily due to the realization that statistically, many of the homes we liked and have lost out on probably went to people making half of what we do and saving a hell of a lot less, but who were simply more reckless than us in being willing to max out their debt-to-income ratio or gamble on an appraisal gap.
For the past several years the mainstream financial wisdom has shifted to scoffing at putting 20% down, with statements like “OK Boomer, you don’t need 20% down” (yes, this is a real article title). While usually true in the context of opportunity cost of otherwise investing the cash if someone is lending you money at a 3% interest rate, the calculus shifts as interest rates rise. How many potential buyers are poorly positioned to shift their strategy financially and can’t quickly increase their down payments?
Every financially conscious individual has a mental threshold of an interest rate that they’re comfortable holding onto for the life of the loan rather than paying it off early, and choosing to invest their excess cash flow into stocks to attempt to capture arbitrage. My comfort level for carrying debt has historically been somewhere between a 4–5% rate depending on the macroeconomic environment.
Let’s take a look at the financial damage that is done to your theoretical monthly mortgage payment as rates rise:
Nothing ground breaking here; borrowing more money gets more expensive as interest rates rise. I picked a $550k home as that is the median for my area. Note that the above figures do not include property taxes and insurance as they’re not relevant to finding the delta, so total monthly payments will be higher than the values in that table.
The pendulum on down payment percentage advice is going to swing back the other way, so get in front of it and prepare to save 20% down if you’re not already on that path.
The housing market will appear to get worse for buyers before it gets better, but it’s an illusion
If nothing else this table highlights the utter absurdity of those people who are trying to argue that home prices will stay flat or even continue to rise as mortgage rates rise. In my previous article analyzing the recent history of home prices and mortgage rates, I speculated that The Federal Reserve’s continued tightening actions will cause a housing price correction, and that they could make a decision as soon as May on rolling Mortgage Backed Securities (MBS) off their balance sheet. Well well, just look at what the March meeting minutes released 1.5 weeks after I wrote that article revealed they had previously plotted behind closed doors!
From a data perspective the housing market will appear to get worse for first time buyers before it gets better. This is due to the lagging nature of home sales data, where the sales you see today went under contract 1.5–2 months ago at lower mortgage rates.
Another incredibly important factor I am not seeing discussed anywhere is the “final FOMO wave” of those buyers who did lock-and-shop pre-approvals offered by some lenders which allows you to pay to lock your rate before shopping for a home. Typically offered as a 60 or 90 day lock, these products will give buyers 30 or 60 days respectively to search and get under contract for a home, allowing the last 30 days for the lender to close.
Depending on the popularity of these products in your area, there will probably still be home shoppers floating around for a few more weeks who have 3.875–4.25% rate locks. Many of these buyers will be desperate to get into any house they can before their rate lock expires and they’d have to swallow a 5% mortgage rate. This could give the illusion for the rest of April that there’s far more demand for homes at these prices in a 5% mortgage rate environment than there truly will be going forward!
I’m going on the record calling a top in the housing market in the coming weeks. That is the conclusion that all data analysis and rational thinking has led me toward since I started researching and heavily investigating The Everything Bubble. It’s not going to be a 2008-tier crash, but it’s not going to be the “soft landing” that The Fed wants people to believe they can engineer after they poured octane on the fire for two years straight. Also, it will be fun to make an official “market timing” declaration and come back to revisit and reflect on this article in the future.
My fellow first time buyers, keep on saving and stay patient a bit longer. As I wrote this article today, Mortgage News Daily updated their benchmark 30 year fixed rate index. The rate for today, April 11th, 2022 is up 0.19% since last Friday, now sitting at 5.25% with 0.4 points. This whole thing may very well implode in a spectacular fashion…