The first thing to ask yourself is exactly how long do you want to stay in the house. Most people don’t know these sorts of things, but should try to make sure to own the house for at least five years.
The Upgrade Cycle
It definitely varies by specific neighborhood — but people 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. Depending on the family, that upgrade cycle can go through a couple of times as people work their way up to a house that they are happy with and is big enough for their family.
The thought seems to be that if you’re making a little more money every year, after three years you’ll be in a position to afford a bigger house. And everyone knows 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.
The Five Year Rule
When you purchase a house, the general rule is that you want to be sure to be in the same location for at least five years.
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. We can easily be talking about thousands of dollars and limiting how often you have to pay out that kind of money is always a good idea.
But you take a second hit when you look at your mortgage statement to see exactly where those monthly checks you send in 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 that mortgage that you’ve made enough progress on the principal that the math actually works out that you’ve gotten a better deal than paying that monthly check to a landlord.
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 interests you need to pay is the highest as well. However, since the monthly payment is the same through the loan (at least with a fixed rate mortgage anyway), more of the payment will be used to cover the interests payments, and therefore less goes towards the principal. As your principle goes down, your interests 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 part 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 question to purchase a home, start paying it down and fixing it up so that you can turn around and rent it out. But if you’re buying just on the basis of what the bank says that you can afford and you don’t want to think about it, stay in the rentals until you’re ready to spend at least five years in the same home.
The five year rule is actually pretty arbitrary, but if you assume that the long term trend of real estate is up, it is easy to see why buying makes sense the longer you stay in the home.
By David Ning.