Thinking of buying a starter home but not sure if it's the right decision for you? Something real estate experts call the Five Year Rule can be a useful guide.
The Five Year Rule is that you don't want to buy a home unless you plan to stay in it for at least five years. Otherwise, it probably doesn't make financial sense.
Like many things in real estate, the Five Year Rule is not a hard and fast one. There are exceptions to it, some of them owing to things you might choose to do differently than other homeowners. But it's a pretty good rule of thumb for most people.
Here are two key reasons why the Five Year Rule makes sense - and two situations where you might be able to get around it.
When you take out a 30-year mortgage, the vast majority of your monthly mortgage payment is going to go toward interest charges for the first few years of the loan. You won't make much progress in building equity during those early years. And building equity is the main reason for buying a home instead of renting in the first place.
Suppose you buy a home with a $200,000 mortgage with a fixed rate of 4.5 percent over 30 years. In the first year, nearly three-quarters of your monthly $1000 mortgage payment (plus taxes and insurance) will go toward interest payments on the loan.
With that loan, after five years you'll have paid the balance down to about $182,000 - or $18,000 in equity. Assuming you could rent the same home for $300 less a month than it would cost to buy it (again including taxes and insurance), after five years of renting you would have saved $18,000 compared to the cost of monthly mortgage payments - though without any accumulated equity. So it's a wash.
Of course, the portion of your mortgage payment that goes toward interest is shrinking all the time, and the five- year point is typically where you begin to get some real traction in building equity, which makes your interest payments fall even faster. So the five-year mark is generally considered the point where your accumulated equity begins to exceed what you might have saved by renting, though it may vary depending on the terms of your loan and the cost of renting vs. buying in your area.
The other main reason for the Five Year Rule is the closing costs that are incurred whenever you buy a home. These costs - the fees for mortgage origination, title insurance, inspections, appraisals, legal costs, etc. - usually run about 3-6 percent of the price of the home. So that's a good reason to avoid frequently trading up to a new home right there.
You'll normally pay the higher figure only if you're buying discount points in order to reduce your mortgage rate - which in itself is not a good idea unless you're going to stay in the home for a long time. But even with the lower 3 percent figure and buying a $220,000 home (assuming a modest 10 percent down payment), you're looking at $6,600 in closing costs.
The longer you own the home, the more those closing costs are spread out over time as part of the month-to-month cost of ownership. Since the five-year mark is about where you start to build equity more quickly, that tends to be about the point where your accumulated equity begins to outweigh the added expense of both closing costs and interest payments, roughly speaking.
Getting around the Five Year Rule
Of course, if you could build equity more quickly - thereby helping to negate the higher month-to-month cost of owning vs. renting - it could be financially worthwhile to trade out of a home much sooner, say after three years.
In a rising home market, you may find that home values are increasing fast enough that the appreciation alone is enough to exceed the expense of interest payments and closing costs in just two or three years. That's what happened to a lot of people in the early 2000s and why many were "flipping" their houses every couple of years to take advantage of the gain.
Of course, that isn't a reliable way of building value - as experience has shown. While historical trends are that homes do tend to rise in value over time, it isn't consistent enough to be able to depend on it over just a five-year period.
You could build equity more quickly by simply paying an additional sum on top of your regular mortgage payment each month - $50, $100, $200, whatever. But because this money is coming out of your pocket and could have just as easily been deposited in a savings account if you were renting, it really doesn't have any effect on the Five Year Rule.
Using sweat equity
A more reliable way to build equity quickly is to buy a home that needs some work done to it and make those improvements yourself. In that way, you can increase the value of the property, sometimes fairly quickly depending on the amount of work to be one, and realize a gain when selling the home only 2-3 years later.
This type of approach can work if you have the skills and knowledge to make most of the improvements yourself. People who are knowledgeable about construction and real estate can often make this work by contracting out all the improvements, but the margin for error is much thinner there. The more of the work you can do yourself, the less you're paying out of pocket. But this approach isn't for everyone.