When I first considered buying a house, my entire family got involved. I have the luck of being related to real estate agents, investors, and other experts that are more than happy to give advice about buying a property — even before you ask.
The first thing they asked me was exactly how long I expected to stay in the house. Though I didn’t know the exact amount of time, they wanted to make sure that I’d own the house for at least five years.
Why’s that? What’s the five year rule for buying a house?
The Upgrade Cycle
It definitely varies by geographic area — if not by specific neighborhood — but a lot of folks near me will buy a townhouse or condo as their starter home. After about three years, they’ll start looking for a bigger place to upgrade to, either a bigger townhouse or a single family home. This upgrade cycle will repeat itself a few times, as people work their way up to a house that they are happy with and that is big enough for their family.
The thought seems to be that if you’re making a little more money every year, you’ll be in a position to afford a bigger house in three years time. And everyone
knows assumes that buying is more cost-effective than renting — as long as you’re paying down the principal on your mortgage, you’re going to come out ahead.
But with an upgrade cycle of about three years, there’s a good chance that you will lose money.
The Five Year Rule
When you purchase a house, the general rule is that you want to be sure you’ll be in the same location for at least five years. Otherwise, you’re probably going to take a hit financially.
The first hit is your closing costs. Every time you go through closing — buying and selling — money hits the table. Depending on where your house happens to be, the buyers and sellers pay different amounts, but everyone pays something. This can easily add up to thousands of dollars, and limiting how often you have to pay that kind of money is always a good idea.
And you take a second hit when you look at your mortgage statement to see exactly where your monthly payments are going. The way mortgages are structured, you pay much more interest in the first few years that you own a house. Usually, it isn’t until you’re about five years into paying down your mortgage that you’ve made enough progress on the principal to make it a better deal than paying rent each month.
David’s Note: When you take out a mortgage, you are paying an interest rate on what you owe. So, in the first year, when the principal is highest, the interest you need to pay is also the highest. However, since the monthly payment is the same throughout the term of the loan (at least with a fixed rate mortgage), more of the payment will be used to cover the interest payments, meaning less is going towards the principal. As your principal goes down, your interest payments will go down, leaving more of your check to go towards the principal.
If you can wait at least five years to move, you’re in a better position to be ahead of the game.
Defeating the Five Year Rule
Five years is a generality. If you add in a couple of other factors, you can make buying a house that you don’t plan to stay in long-term a better choice.
The biggest factor is how much you’re going to pay on your mortgage. A lot of people buy as much house as they can afford, according to what lenders offer them. That’s usually the upper end of what you can financially manage. If, however, you buy at the lower end of what you can afford and make extra payments, you can pay off a bigger chunk of the principal. You need to run the numbers for the specific house you’ve got your eye on, but you can often come out ahead.
You may also consider buying a house that you won’t stay in for five years — but that you also won’t turn around and sell. It’s not out of the question to purchase a house, start paying it down, and fix it up so that you can turn rent it out. You do need to be careful that you’re choosing a house that you can afford in addition to a mortgage for your next home, even if you can’t find a renter,. There are plenty of other arrangements that can work out similarly, but you need to study up on real estate before making such a choice.
Bottom line: if you know you’re going to buy a house based on what the bank says you can afford, and you don’t want to think about renting it out, don’t purchase a house until you’re ready to spend at least five years in it.
David’s Note: Here’s a quick and dirty formula that you can use to help you figure out whether it’s better to buy or rent, which works with any duration of ownership. Try to calculate: Seller and Buyer Agent Fees When You Sell + Purchase Price + Maintenance Cost for the Time of Occupancy + Interest Paid on Mortgage + Investment Gains from Your Down Payment + Taxes Paid (Such as Property Tax) + Closing Costs – Selling Price. This number could come out negative or positive, but if it’s lower than the rent you would have paid during the same time frame, then you would be better off buying. If the number is higher, meaning that the selling price wasn’t high enough to cover all those costs, then renting would be the more cost-effective choice.
Do you adhere to the five year rule when buying a house?