Where should I keep my down payment savings?

Saving up for a down payment is the first major step towards buying a home. And because most people can't save even a percentage of the purchase price all that quickly, knowing where to open a down payment fund is an important thing to consider as you prepare to go house-hunting and make the big purchase.

Why Do I Need a Down Payment?

Most prospective homeowners need to borrow money to help with the cost. To get that money, they apply for mortgage loans from a bank. When granting such loans banks asks for down payments, which helps to reduce their risk. For obvious reasons, most banks prefer to do business with borrowers who can make significant down payments.

How Much Should I Save?

Banks prefer borrowers who have at least a fifth of the asking price on hand. (For high-risk borrowers, the percentage banks look for is often much higher.) To begin with, look at the types of homes you want to buy, calculate 20% of their asking price – what you end up with will be the amount that you'll want to save. If you have excellent credit, or qualify for certain programs, you may be able to secure a loan with less than 20% down. But keep in mind: such loans require the borrower to pay private mortgage insurance (PMI), at an additional cost.

Of course, if you're able to do so, you can make a larger down payment, which will result in lower monthly payments. When I purchased my home, I put down 40% of the purchase price and knocked my monthly payment down to a much more comfortable level. To calculate the numbers involved, you can use a loan amortization schedule. 

Where Should I Put It?

Now that you know how much you'll need to save, the next step is to find a place to keep the savings. Depending on your timeline, here are a few good options:

A Savings Account: The most straight-forward strategy involves opening a savings account at the bank where you do your checking. Existing customers can open savings accounts very quickly, make transfers from their checking accounts, or set up recurring transfers from checking on paydays.

The downside is, banks tend to have very low interest rates. When you use a savings account at your bank, you're choosing convenience over return on investment.

High Interest Online Savings Account: If you want to earn more interest, without sacrificing the safety of FDIC-insured savings, you might prefer a high interest online savings account. This is the type of account I used for my down payment fund.

High interest savings accounts are available from a variety of banks, and often pay 10-20 times the interest rate on regular accounts. Online banks, which have much lower costs, can pay higher interest rates than brick-and-mortars. Even so, the interest rate with any savings account won't be too much to brag about.

Investment Account: If you can afford to wait, consider putting your money into an investment account at any major brokerage. With investment accounts, you can buy stocks, bonds, and funds that pay much higher interest rates. However, there are bigger risks associated with such investments.

Investment accounts are not FDIC- insured. Stock prices fluctuate, and you can lose some of your investment, or all of it. But, as a whole, the stock market has always recovered from downturns and reached new highs. If you can wait things out, in cases where the market turns south, an investment accounts offers the best potential while you save up for your purchase. If you're are unsure of how to choose a broker or you can check out Investopedia's list of the best online stock brokers.

The Bottom Line

If you want convenience, you'll do perfectly well with a saving account at your existing bank. If you want a little more return, and don’t mind waiting on transfers between banks, you can look to an online bank and earn more interest. If you can take the risk, investment accounts offer the best returns, but might go down in value in the short term. You'd need a longer horizon before buying to be safe.

Being honest about your goals will help you make the best-informed decision. Given that you're down payment is likely cost you tens of thousands of dollars, it's not something you'll want to rush into, or risk messing up. So research carefully, and make a decision that you'll end up being comfortable with.