How to Decide if You Should Save for a House or Invest — The Complete Guide

Investing in your future is one of the paths to financial wellness. Owning a home and contributing to retirement are two of the main ways Americans build wealth. There’s no doubt that a diverse portfolio will help withstand the market’s inevitable highs and lows, but you may be wondering where to focus your funds first. Perhaps you’re on the hunt for your first home, or you’ve been wondering if you should increase your monthly contribution to a retirement or investment account. Maybe you’re figuring out if you can do both.

If you’re considering whether to save for a house or invest in your retirement first, you’ve come to the right place. We consulted personal finance and real estate experts and dove into data to take a closer look at the benefits and risks of each, along with down payment recommendations, so you can make a better-informed decision.

Which is better, homeownership or investing?

There are benefits and risks in any investment you make. “There’s no right or wrong answer as to whether one should save for retirement or buy a house,” says RJ Weiss, certified financial planner and founder of The Ways to Wealth. “It all comes down to the trade-offs of prioritizing one goal over the other, and that’s deeply personal.”

In other words, approach your decision about whether to save for a house or invest in retirement by understanding the pros and cons of each. Then identify your priorities.

The case for homeownership

For many Americans, owning a home is the most common way to reliably build wealth. Monthly mortgage payments offer built-in savings through equity gains. Prices tend to increase over time, so a home purchase is generally perceived as a smart investment. In fact, price appreciation has risen relatively consistently on a national level for decades, with the exception of the Great Recession from 2007 to 2009. Real estate is location specific however, and appreciation rates can vary significantly from region to region. Even so, major regions in the U.S. have experienced a similar positive trajectory over the same period with steady home appreciation. In fact, most metros are currently experiencing double-digit growth in year-over-year home price increases, especially in the Northeast (22.1%) and West (18.0%).

You’ll want to be sure you’ve kept the home long enough to recoup your transaction costs — real estate agent fees, closing costs, and any repairs or maintenance done to the home to prepare for sale. These costs are anywhere between 10% to 15% of the home’s purchase price, and you’re looking at about five years before a home appreciates in value enough to cover them.

Homeownership is a way to hedge against inflation by keeping housing costs static and predictable. If you use a fixed-rate mortgage, your principal and interest will remain the same throughout the life of the loan, though your property taxes and subsequent homeowner’s insurance can increase over time. Home rentals, on the other hand, are subject to regular increases and tend to rise with inflation. And don’t forget about the tax benefits that come with a home purchase. You can often deduct a variety of expenses, including mortgage interest, property taxes, and discount points associated with your loan to help offset other homeownership costs.

The case for investing

When it comes to retirement savings, the early bird gets the worm. Or, in the language of investing, the nest egg. Start saving early and often to take advantage of compound interest and dollar cost averaging. Based on historical performance, both allow your money to make you even more money long term. With compound interest, you’re earning interest on your contributions plus the investment gains from your interest. Dollar cost averaging refers to regularly investing fixed dollar amounts in the same fund over a long period of time to withstand market lows and highs (a 401(k) is one example of this).

When investing money in stocks or mutual funds, you have more control over where you invest, how, and how much. Most employer retirement plans offer a variety of options from which to choose, from very low to high risk. For example, a lower risk fund would typically offer a higher bond-to-stock ratio, while a high-risk fund would include more stocks than bonds. The 401(k) plan is the most common, followed by the Roth 401(k), 403(b), and SIMPLE Plans. If you’re self-employed, you also have options: traditional or Roth IRA, Solo 401(k), or SIMPLE IRA.

Unlike real estate, there’s a lower cost of entry to mutual fund and stock market investing. You don’t need to have a lot of cash to start like you would for a home down payment and transaction costs. You can begin stock or mutual fund investing with $500 to $5,000, depending on fund minimums. With employer-sponsored retirement plans, you typically don’t need a lump sum to start — your investment contributions are simply deducted from your regular paychecks. And don’t forget about the benefit of employer matching. Your company may offer partial or dollar-for-dollar matching up to a certain percentage of your contribution (up to 3% to 6% is common). Free money to invest!

There’s also a faster way out of your investment if a stock or mutual fund isn’t performing to your expectations. Simply trade or sell the stock or fund, though discuss with your tax attorney or accountant to minimize your tax burden.

Evaluating long-term performance

What’s considered a good rate of return on your home purchase? While there’s no reliable historical data tracking individual real estate investments, the average annual return on a home sale is 8.56% to 9.96%. This is after factoring in the down payment, transaction costs, and ongoing homeownership costs over the average number of years a family keeps a home.

There is historical data for stock market investment that dates back to 1926. When taking the long view, the stock market performance averages 10.3% annually from 1926 to 2020. While the market tends to outperform real estate investing, this data reflects a nearly 100-year span. In reality, the market experiences peaks and valleys with periods of highs and lows (i.e. the Great Depression and Great Recession). Because it’s volatile, gains are contingent on your willingness to stick it out long enough to ride out the inevitable ups and downs (just like real estate).

Balancing risk

There’s risk in any investment. In a home purchase, whether you plan to put down 20% or 10%, that’s a lot of money! The same is true for retirement saving or any time you invest your hard-earned savings. The last recession taught millions of families some hard truths about what could happen to a real estate or retirement investment in a rapidly declining market. Home prices fell by about 30% from 2006 to 2009, while the S&P 500 index decreased by 57 points in a similar time period.

No one doubts the inherent risk of stock market investing and its volatility. In fact, according to Boston University professor, economist, and author Laurence Kotlikoff, today’s risk is at an all-time high. “On a risk-adjusted basis, the return to the stock market is negative right now, it’s negative about 25 basis points, because that’s what you can earn on inflation index bonds.”

Timing the market may also factor into the decision of whether to focus on saving for a down payment or retirement. There’s a sense of unease among first-time homebuyers about getting left behind in a rapidly changing market, which may impact their investment priorities.

“Most of the first-time homebuyers I have worked with, their goal is to get into a house,” says Maureen McDermut, a Santa Barbara-based agent with more than 20 years of experience who completes 23% more transactions than the average agent in the area. “Saving for retirement isn’t on their radar.”

Many buyers are looking for a home to build and grow their families, and they’re already facing challenges saving enough for a down payment while home prices continue to rise. The concern is that if they don’t enter the market soon while interest rates remain low, they may lose their chance to buy a home for a long time. “They are anxious to buy while rates are low. They are fearful they will be priced out of the market,” says McDermut.

Saving for a house and retirement at the same time

Taking the pros and cons of investment or down payment saving into consideration, you still need a place to live. Housing is still part of your monthly budget, so why shouldn’t that expense be for a home to build equity in something that appreciates in value?

While renting can be a good choice in some areas where home prices significantly outpace the cost of rent like San Francisco, Seattle, or Boston, buying a home is still often considered a better long-term option. A home purchase is unique because it’s shelter and an investment opportunity. You need a place to hang your hat, and if you’re living in an area where it doesn’t cost much more to own than rent, consider building your own equity instead of someone else’s.

Some personal finance experts recommend putting a hold on retirement savings contributions while saving for a down payment. But if you’re participating in an employer-sponsored plan with matching contributions, don’t forget about that free money available from employer matching in your 401(k).

“Buying a home and saving for retirement are not incompatible goals,” says Weiss. “One thing to consider is lowering your 401(k) contribution to get the maximum match from your employer, while the rest is set aside to save for a down payment.”

For example, if you’re contributing 10% of each paycheck to your retirement account and your employer matches up to 6%, you may consider reducing your contribution to 6% while saving for a house. This way you’re still making regular investment contributions along with your employer’s match. Then, once you’ve saved your down payment, you can increase your contribution again.

Saving for a down payment

Saving for a house can be tricky (and time consuming) because most of us don’t have lots of extra cash laying around after paying monthly expenses. So how much of a down payment is really necessary? The short answer: It depends.

Debunking the 20% myth

Conventional wisdom says you’ll need to save 20% of the purchase price. The advantage of a larger down payment is that the more you pay upfront, the smaller your loan (and your monthly payments). Putting down 20% also helps you avoid having to pay private mortgage insurance (PMI), which protects the lender in case you are no longer able to make payments on your loan (note that PMI only applies to conventional loans).

“A 20% down payment is something I prefer, as a 20% down payment will qualify someone for the lowest mortgage rates,” says Weiss. He notes, however, that it’s less of an issue in this current market where interest rates remain at historical lows.

But borrowers don’t actually need to put down 20% on a home. The average down payment for first-time buyers is 7%, and some loan programs require as little as 3% or even none at all. Bottom line, when saving for a down payment on a house, you have options:

• Conventional loans require at little as a 3% down payment for certain borrowers
• FHA loans: as low as 3.5%
• USDA loans (for rural property owners): no down payment required
• VA loans: no down payment required

When planning to save for a down payment, keep in mind other costs associated with a home purchase. Include the transaction’s closing costs and your moving costs in your upfront savings. If the home isn’t as turnkey as you’d like, plan to sock away some extra money for necessary repairs or improvements at move-in.

Ways to save for a down payment

When saving for a down payment, think beyond the standard bank savings account. You’ll want your savings to make some money for you while keeping your risk level low.

While the stock market may be regarded by some as too unpredictable for short-term savings, you can do better than .06%, the national average savings account interest rate. Consider options that don’t tie up your money yet increase your funds faster, like a high-yield savings account or money market account that offer better returns than a basic savings account. Online banks can typically offer a better APY or interest rate than traditional banks, but be sure your choice is FDIC insured for your protection. CDs can also make a nice down payment nest egg by offering termed- and fixed-interest rates. Be sure the term length matures before you begin house hunting so funds are available when making offers.

Using retirement savings for a down payment

If you’re thinking about tapping into your retirement account to help with a down payment, you’re not alone. In 2020, 7% of homebuyers used money from retirement savings to cover home purchase costs. While this may be a good option for some people, it does come with risks.

Expect to pay taxes on any withdrawals from your 401(k) or retirement account, and this is on top of a 10% penalty you’ll owe if you’re under the age of 59 ½. “I prefer not to touch retirement funds, as it’s very hard to make up retirement contributions,“ says Weiss.

Borrowing from your 401(k) is another option. You’re essentially loaning money to yourself, and it could free up some cash in the short term for a one-time purchase like a down payment for a house. Because it’s not a withdrawal, you won’t pay any taxes or penalty fees (unless you default on repayment), which makes it an attractive choice for some homebuyers. You will have to pay interest on the amount you borrow and pay yourself back, typically within 5 years. If you plan to leave your job before you’ve repaid what you’ve borrowed, you typically must pay the remaining balance in full.

Down payment assistance options

Coming up with a down payment can be challenging, especially if home prices are going up faster than you can save. Thankfully, you may not have to save as much as you think. You may be eligible for a no-closing-cost loan, a loan where closing costs are rolled into your mortgage, and still keep monthly mortgage payments manageable. Options and requirements vary, so check with your preferred lender on what they offer. Some advantageous buyers are able to negotiate with sellers to cover some or all of the closing costs, however don’t count on it in 2021’s seller’s market.

Fortunately there are federal and state programs that offer assistance to increase homeownership accessibility. Typically reserved for first-time buyers, they offer down payment assistance and paths to homeownership through grants, low-cost loans, and the purchase of foreclosed properties. HUD programs like Good Neighbor Next Door and HUD Homes can be attractive options for some, and there are also programs at the state and local levels. Check each program’s eligibility requirements for details.

Assemble your financial A-team

Having an understanding of your financial goals and lifestyle needs is the first step toward making an informed decision about whether to save for a house or invest in your retirement. An experienced real estate professional and financial advisor can offer insights specific to your situation so you can own a piece of the American dream, whether it’s in a house or the stock market.

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