Can You Invest Your House Down Payment In The Stock Market?

by Mike Holman

Jordan has agreed to help out the crack writing staff here at Four Pillars by contributing the occasional post.  He is a young guy living and working from home in Vancouver with his wife and 2 young kids.  Jordan is a computer geek at heart and last year discovered he also had a hidden passion for personal finance with the goal of “early financial retirement”. He will write about various financial ideas and situations that he comes across and share resources and useful tools.

When is it ok to invest your house down payment in the stock market?  I’ve always understood that a house down payment shouldn’t be invested in the stock market.  Actually the rule probably is if the time horizon of your money is less than 5 years, it shouldn’t be in the stock market. In fact if someone asked me for my advice I would say exactly the same thing. But I wanted to explore and research the idea for myself, so here is a new page in the Amateur Investor’s Manifesto.

Stock markets are volatile

The logic behind this rule is that the stock market is very volatile over short periods of time. As we clearly saw last year someone fully invested in the market could have easily lost 50%. Over the long term it’s much easier to predict a positive outcome.   As you’ll often hear – “the market always goes up” and “there has never been a 10 year period on the S&P 500 that went down”.  Unfortunately after last year that is no longer true.

So the alternative is to invest in a GIC or high interest savings account which is protected up to $100,000 per account / per bank or $200,000 for couples. The chance of a bank failure seems extremely low in Canada, the more real risk is high inflation eating away your money’s buying power.

Adding equities to your house down payment

What about a short term diversified portfolio? Shouldn’t it be possible to increase the return by taking on a small amount of risk? Let’s see what would have happened to an 80% GIC / 20% stock portfolio that’s invested for just one year. The asset allocation is the ultra conservative portfolio recommended in “The Smartest Investment Book You’ll Ever Read”.  In my test scenarios I’ll be using a $100,000 down payment.

* 80% / $80,000 ING Direct 1 Year GIC
* 10% / $10,000 iShares S&P 500 Index (XSP)
* 8% / $8,000 iShares MSCI EAFE Index (XIN)

* 2% / $2,000 iShares Canadian Index (XIC)

·

Year

GIC

Stocks

Inflation

80/20 Return

80/20 Result

Safe Return

Safe Result

Diff

2008

4.10%

-37.50%

-2.00%

(6,220)

93,780

2,100

102,100

-8.1%

2007

3.50%

4.00%

-1.97%

1,630

101,630

1,530

101,530

0.1%

2006

2.75%

14.90%

-2.47%

2,710

102,710

280

100,280

2.4%

2005

2.50%

9.10%

-1.39%

2,430

102,430

1,110

101,110

1.3%

2004

2.50%

6.30%

-1.99%

1,270

101,270

510

100,510

0.8%

2003

2.75%

7.60%

-2.42%

1,300

101,300

330

100,330

1.0%

2002

2.75%

-21.80%

-1.58%

(3,740)

96,260

1,170

101,170

-4.9%

Inflation is the Core CPI from the Bank of Canada which actually excludes inflation of housing prices, but it does show the buying power of your savings goes down over time.

I wasn’t able to look up the GIC rates for 2002-2006 so I used ING’s historic high interest savings account rate for the beginning of each year which is usually just a bit lower then a GIC.

Oout of the 7 years tested the worst result was underperformance of $8,320, or 8.1%.  The best result was $2,430 of overperformance in 2006. So a slight loss isn’t much fun but not the end of the world.  The gains aren’t huge, but they do help a bit. I think with careful consideration to exactly what your goal is and your risk tolerance it is possible to invest for short term goals because on average the market goes up.

Dealing with a short fall

You basically have 4 options if you come up short, which is very likely for short term investing:

  1. You will need to adjust your goal such as delaying when you buy a house or looking for a lower cost house.
  2. Make up the short fall with income cash flow by redirecting savings before the absolute last moment possible or paying for expenses (ie tuition) as they come up
  3. Borrowing the short fall from another savings account such as a non-RRSP retirement account.
  4. Borrow more money on the mortgage or open up a line of credit.

Can you fully invest your down payment in the stock market?

Yes, in certain situations I believe so.  If you have enough savings outside of your short term savings goal to replenish it if there is a catastrophic loss then you should be able to be fully invested. If you realize the worst annual return possible is -50%, and your short term goal is $100,000 then you need to have an additional 52% ($52,000) in guaranteed savings to cover the loss & estimated inflation. If that other money is also fully invested then you would need to have 104% more ($104,000). This will help you ensure you would end up with $100,000 after a 50% drop.

It definitely wouldn’t be much fun seeing $100,000 of retirement savings vanish just so you could afford your $100,000 down payment, but it’s not really any more risky if you would have been fully invested anyways. The flip side is if you are lucky and there is a bull market, you will either have a larger down payment or you can add the extra money into your already larger retirement account. If you had been invested in 2006 you would have had your $100,000 down payment and your retirement account would have risen to $124,860 (+24%) instead of $112,430.

It’s worth repeating: I would still not recommend investing a house down payment in the stock market. It’s just not a good idea for most people. If you do decide to do it then: know your risks, be conservative, make sure you can fully cover a short fall and hang on for a bumpy ride.

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{ 16 comments… read them below or add one }

1 Silicon Prairie

It seems like in this example the potential gains from a small exposure are pretty small (a maximum of 2.4% in one year won’t change your options that much). It doesn’t cover a very long period though so the future may be different.

Putting short-term savings in the stock market doesn’t seem like a very efficient way to manage risks overall. If you want to go that way why not separate your down payment and another investment to pay off the mortgage in 10 years? Then you can take bigger risks with the long-term investment.

2 Traciatim

You also forgot to take taxes out of the equation. For example, lets say for instance you had the 100K 100% in a GIC, in 2008 you woudl have earned 4.1%, or 4100 dollars. On this you would pay Federal and Provincial tax probably somewhere close to 40% of your income, so you would keep 2460, ending with a total of $102,460. On this inflation would have taken it’s toll and you now lose 2% of the total value, which is a loss of about $2050 worth of your monies buying power. This leaves you with a $410 gain, or 0.41% of your actual ‘money power’ to buy your home.

Of course, since home prices appreciate at the rate of inflation (Generally) then your 500K home that you were saving for is now $510,000 . . . so you were better off buying it before you started anyway if you had the 100K sitting around.

Now, in certain cities in the current market where things went crazy you may as well wait, if home prices keep dropping things will work out in your favour, but if you have 100K lying around in wait for a home . . . you can probably afford a house, so get buying a place you like.

3 nobleea

I did this very same thing and was lucky or smart. Probably a bit of both. I contributed the 20K to the RRSP and then withdrew it 91 days later under the HBP. While it was invested in the RRSP, I invested it in half in money market, and half in precious metals fund. The whole thing went up 11% in 90 days. I took the 20K out and left the extra 2K in the RRSP as earned money. The 20K was borrowed too, so I had to give it back to the bank and I got the tax refund.

Maybe 70% luck and 30% smart.

4 Canadian Capitalist

I wouldn’t fully invest a down payment in the stock market. Typically, it is people who are just starting out who are saving for a down payment and they are not likely to have other assets. If they invest the whole shebang in the market and lose a significant chunk, the more likely outcome is that they would be scarred out of the market in the future fearing more losses.

5 Silicon Prairie

Housing price appreciation is a good point (apart from the last few months that is), but hopefully if you’re saving up for a down payment the effect of your savings is greater than the increase in prices. I don’t think there’s any reliable investments that will give you enough guaranteed performance in the short term to really make a difference compared to normal price increases in the market.

If you’re looking at that inflation should be removed from the calculations as well since it’s included in the price increases.

If you’re saving a lot, getting a decent return, and watching prices drop you’ll do very well – 2 out of 3 isn’t bad either 🙂

6 Jordan

@ Traciatim

Good points, your right that taxes have a very significant impact of the returns of the GIC portion. It’s hard to give an absolute example since it depends greatly on your marginal rate, and also the possibility of using the First Time Home Buyers’ Program where $20-40k could have been shielded from taxes in RRSP(s).

We’re also coming off of years where many markets have had much higher then normal price inflation. If anyone was able to jump out before the peak they will be significantly better off to wait out some of the declines.

@ nobleea
That sounds exactly like a very risky situation that should have be avoided. If gold had gone down by the same amount would you have had enough funds in reserve to make up for the short fall?

@ CC
That’s a good point that there must be a very high correlation between people saving a down payment also being first time buyers and also not having much other networth to make up a significant short fall. Maybe that makes up more of the conventional rule to not invest a down payment then the actual reason why.

I should have suggested the full investment option is probably more suitable to those who have sold out during a housing market peak, or those who have chosen to remain out of a housing market because they believe it is fundamentally over priced.

A good example is when rental prices are significantly lower then buying with 20% down or when buying requires a such a high portion of income that the median salary can not come close to affording it.

7 nobleea

i don’t mean to say it was a good idea. i’d never recommend it and wouldn’t do it again. it worked out for me, so i can laugh about it now.

it’s really only a concern for first time homebuyers, since most people just shuffle from house to house and don’t actually have the downpayment money saved up anymore (it’s in the house in the form of equity). first time home buyers will usually be younger and more susceptible to extreme ideas. or concepts.

8 Traciatim

Hey Jordan, funny thing is I’m in Nobleea’s boat in the “holy crap, was I ever lucky”. I used my companies RRSP matching to save up for my down payment from around 2002 until March 2007. I then cashed it all in to buy a home and missed out pretty much on all this terrible news as I’m still in the RRSP plan buying to the bottom.

Looking at the CREA stats my city from April 2007 to April 2008 (my close month) real estate values increased something like 10%, and then things area still going up month to month. I’ll see how I fare come April/May to get the YOY increase there too. Of course it helps that in my city average houses go for about 2.7 times average family income, which is just about where they should be to be affordable.

Looking back I couldn’t have timed things much better, but knowing then what I know now I probably wouldn’t have been in equities at all and just kept the company match in a money market.

9 EconStudent

Jordan,

If one has to touch equities, maybe using GIC/option strategy might be better. Again I am still researching on the exact methodology.

Maybe 95% to 98% in GIC and rest in call option of an index etf. The worst case scenario is that you loose everything that you used to buy the call option. It is sort of creating your own protected notes or market linked GIC, whatever they are marketed as.

However, I recommend putting the money into 100% GIC or money market or 1 yr government bond if that is your thing (Phil S likes to buy government bond directly).

By the way, there is no inflation right now. So inflation shouldn’t be a concern.

Jordan, is it possible if I ask you directly for career directions? You can get my email from CC or Four Pillars.

10 Jordan

@EconStudent

I’m really glad to get your suggestions, I actually got the idea to write this based on your comments at CC’s blog. I wanted to test the idea for myself.

Maybe you can explain your call option / gic strategy a bit more? I’ll do some research to try figuring it out, but I don’t really understand it, options are another weak area of my understanding.

Personally I have several options to deal with a shortfall situation. Even with another huge 50% drop in equities I could make up the down payment from retirement savings. I’m self employed and also a US citizen so I’m very lucky that I can also move to a cheaper real estate market.

Based on my family’s situation I’m feeling pretty comfortable fully investing our down payment after I thought about the risks.

In fact if the Metro Vancouver market doesn’t have a +20% drop in 2009 I’ll probably pull up roots and move the family. But I have a pretty good/bad feeling this guess will come true, I think Mohican is a pretty smart guy at seeing the truth in our market.

I also sent you a personal email if you wanted to talk off site.

11 Dividend Growth Investor

I would invest a portion of the downpayment in the stock market, depending on the interest rate i could receive and the time horizon in years I have.

If I have a 10 year time horizon and I could somehow manage to earn a 7% return on my GIc or CD in US ( i know those rates are unbelievable they are jsut for illustration purposes) that means that my principal will double in a decade. So if I invest 50% in stocks and 50% in GIc/CD earning me 7% ( which I could compound at 7%) then in one decade the WORST thing that will happen to me is to only have 10K ( if stock markets dropped to 0 and all dividends were reinvested in what essentially became a worthless stock).

Now if you can’t reinvest the CD/GIC at 7%, then the most stock allocation you could afford is 31,1%..

Of course if interest rates drop you will need a higher fixed income allocation..

12 EconStudent

Here is a theoretical example of option/GIC mix for one year.

Assumption: You start off with 100,000 and you need 100,000 after 1 year for housing downpayment. 1 GIC offers 4.0%. X is an index etf. X is 100 dollars a share. X’s 100 dollar call option ending in 6 month month is 10 dollars per contract.

Amount that you need to put in GIC:
100,000/1.04 = 96154

Amount that you can buy options with:
100,000 – 96154 = 3846

Lets save 146 dollars for brokerage comission cost.

Amount of options that can be bought: 370 contracts.

Potential good case scenario:
X rises to 125. X 100 dollar call option worth 30 dollars as a result. You sell 370 contracts at 30 dollars each. You received 11100.

Your total amount at the end of year one would be: 100,000 + 11,100 = 111,100.

Worst Case Scenario:
Your options are worth zero due to fact X falls in price.
Your total amount at the end of year one would be: 100,000 + 0 = 100,000

In the best case scenario, X went up by 25%, but your total return only went up by 11.1%. Is the market participation rate equivalent to 11.1/25 = 44.4% in terms of financial engineering? I am not very sure. Your bank salespeople will tell you this is very dangerous and do not do this at home and try to sell you their Market Riser GIC, Principal Protected Notes, etc. I think as long as you understand options: this GIC/options mix is quite doable.

Warning: Due to recent volatility, options have been very expensive lately.

13 Four Pillars

Econ – that certainly is an interesting strategy. I think the success would definitely depend on the cost of the options which as you mentioned is fairly high.

For anyone who isn’t familiar with options (I’m no expert) – volatility of the underlying securities is one of the key factors in the options price.

This post explains call options fairly well:

http://www.milliondollarjourney.com/how-call-options-work-i-the-basics.htm

14 Writer's Coin

As soon as I saw the title of the post I knew what the answer should be. No way you should put a short-term pile of money into a long-term machine!

15 Jordan

@ Writer’s Coin

That’s a good safe common sense response for most situations. The discussion I wanted to create was to ask why is that?

Just based on sheer random luck (which might be all you have for a 1 year time horizon) the market goes up more years then down right?

16 Howard hare

TD offer some very good corporate bonds yielding 6% plus, I would avoid this stock market and buy these bonds.

I am 100% bonds, in my case it is return OF not ON, Capital.

Plus 55, people should not own stocks, cut your spending and stay with short term bonds.

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