Hang on to your down payment money

How to invest cash set aside for a down payment, if your time horizon is two years or less.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

NEW YORK (Money) -- Question: My wife and I have two small kids and we're saving for a house that we'd like to buy within the next two years. We've got a significant pot of cash (more than $100,000) that we almost invested before the market tanked, but thankfully did not. I'm now wondering, however, whether I should invest some or all of it to grow our house fund more quickly or whether I should just keep this money liquid. What do you think? -- Dave, Boston, Mass.

Answer: I'm almost at a loss about what to say, Dave. I mean, you've already dodged one bullet with this cash. But here you are just a year later ready to throw yourself into the line of fire.

Let me be clear about this: Any money you're absolutely, positively going to need within the next two years -- whether to buy a house, pay college tuition, start a business, serve as an emergency reserve, whatever -- should not be invested in the stock market. Period.

Liquidity isn't the issue. Stocks and stock mutual funds are plenty liquid. You can sell them any trading day and have cash in your hands in a matter of days.

The real issue is volatility. If you invest this money in stocks, you can't be sure how much of it you'll have when you're ready to head to the closing table. If the markets are kind, you could end up with a lot more than $100,000, which would be terrific. But if the markets turn against you, you could be left with a lot less, which could wreak havoc with your house-buying plans.

I can understand why you might be tempted to invest some of this money in the market. Maybe you're thinking, hey, stocks have already taken a big dive recently. What are the chances of the market swooning again within the next couple of years? Or perhaps you figure that since the market's been doing so well since March, it's clearly on the road to recovery. So why not jump on board for some real gains, as opposed to those minuscule interest rates that money-market funds and CDs are paying?

Well, such musings could be on target. Or not. The fact is that you just can't be sure what stock prices will do in the short-term. That's true during times when the economy is cruising along without major problems, and it's certainly the case when the economy is still digging out of the worst credit crisis and recession since the Great Depression.

By no means am I suggesting that no one should invest in stocks now. As I've noted before even despite today's heightened sense of uncertainty, I believe stocks deserve a place in a diversified portfolio when one is investing for the long-term.

But you're in a different position than someone investing for a goal that's many years off. A long-term investor has time to rebound from market setbacks. You don't.

Now, is it possible that you might find a combination of stocks and bonds that will give you a shot at a little extra return without unduly jeopardizing your chances of having enough money when you're ready to buy?

Sure, that's theoretically possible. You could go to a calculator like Morningstar's Asset Allocator, plug in how much money you have, how much you plan to save and how much you want to accumulate -- and then move the sliders around to see how different combinations of stocks, bonds and cash affect your odds of reaching your goal.

But, frankly, in a case like this, where you have a very short-time period and you really need to act within that time frame -- i.e., postponing your home purchase by a few years isn't a viable option -- why subject yourself to even a small chance of having your plans fall through? You're better off taking the more conservative route and avoiding stocks and bonds altogether. After all, your goal here isn't to boost your returns, but to be sure you'll have the money you need when you need it.

So if investing in stocks and bonds is out, where should your money go?

Basically, cash equivalents where your principal isn't at risk. That pretty much means money-market funds, money-market accounts (for the difference between the two, click here and short-term CDs (those with maturities of say, one-year or less). And with money-market fund yields barely in the positive range, you're really talking either money-market accounts or short-term CDs, if you want a decent return.

Alas, "decent" isn't much these days. You'll get 1% or a bit more on average with money-market accounts and maybe a little extra on six-month and one-year CDs (although you can beat the averages with a little shopping around). But, remember, it's security you're after here, not lofty returns.

One final note: I don't know how much flexibility you have in your two-year time frame. But if you have some wiggle room, you might want to consider having a contract in place before May 1 and closing before July 1 of next year. If do that, you may be able to qualify for a tax credit under the recently passed Worker, Homeownership, and Business Assistance Act of 2009. This legislation, which extends and expands an earlier version of the tax credit, provides a tax credit of as much as $8,000 for first-time homebuyers or up to $6,500 for certain repeat buyers.

This being a federal program, all sorts of rules, regulations and eligibility standards apply, but you can get the rundown on those by clicking here and here.

Of course, you don't want to buy if you're not really ready just to get the tax credit. But if your finances are in order and you've found a home that you, your wife and those two kids like, a nice tax credit could take some of the sting out of having your house stash languish in those low-yielding accounts. To top of page

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