Lån: Purchasing a House and the Five Year Rule

April 19, 2022 Off By Laquitta

Are you thinking of purchasing a starter property but not sure if it is the right one for you? Something property or real estate professionals call the Five-Year Rule can be a very useful guide. This rule is that individuals do not want to purchase a house unless they plan to stay in it for five years or more.

Otherwise, it probably does not make a lot of sense financially. Like most things in this industry, the Five-Year Rule (FYR) is not a fast and hard one. There are various exceptions to it, some of these exceptions owing to things people might opt to do differently compared to other property owners. But it is an excellent rule of thumb for a lot of individuals. Here are some reasons why this rule makes tons of sense, as well as situations where people can get around it.

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Equity and interest payments

When individuals take out a thirty-year housing debenture, most of the borrower’s monthly loan payment is going to go towards the interest charge for the first couple of years of the debenture term. Individuals will not make a lot of progress in building home equity during the early years.

And building property equity is the biggest reason for purchasing a house than renting in the first place. Suppose individuals purchase a house with a two hundred thousand dollar mortgage with a fixed IR (interest rate) of 4.5{f81c16c78281d5946402c9908c3cc93ce8a08e00599b0629d895a059cbc63ad3} over thirty years.

During the first year, more or less three-quarters of their monthly one thousand dollar loan payment (plus insurance and taxes) will go towards paying the IR of the debenture. With that credit, after five years, individuals will have paid balances down to around $182,000 – or eighteen thousand dollars in home equity.

Assuming the borrower could rent the same property for three hundred dollars less per month compared to what it will cost to purchase it (again including insurance and taxes), after renting for five years, it would save individuals eighteen thousand dollars compared to the cost of monthly amortization – although without accumulating equity. So it is a wash.

Of course, the part of the monthly amortization that goes towards the IR is shrinking all the time. The five-year point is usually where people start to get some real grip on building home equity, which makes their IR payments fall faster. So the five-year point is usually considered the mark where individuals accumulated starts to exceed what they might have saved a lot of money by renting a property. However, it may differ depending on the terms of their debenture, as well as the cost of renting versus purchasing in their area.

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Getting around this rule

Of course, if individuals could create home equity a lot quicker – thereby helping them negate the higher monthly cost of renting versus owning – it could be financially valuable to trade out a house a lot sooner, maybe three to five years. In a rising housing market, people may find that property values are shooting up fast enough to appreciate the property alone to exceed expenses of closing costs and interest payments in two to three years.

A lot of individuals experienced these things in the early 2000s. It is also the reason why a lot of property owners flip their homes every year to take advantage of the benefits. Of course, that is not the best way of building value, according to experts.

While trends in the past show that properties do tend to go up in value in the long run, it is not consistent enough to be able to depend on these things over just the five-year term. People could create equity a lot quicker by simply paying more money on top of their regular monthly amortization. But since these funds are coming out of their pocket and could have just been deposited in their savings account if they were renting their house, it does not have any negative effect on the Five-Year mark.

Closing costs

Another reason for this rule is the closing costs that are sustained whenever people purchase a house. Closing costs or the fees for housing loan origination, inspection, title insurance, legal costs, or appraisals usually run about three to six percent of the property price. That is an excellent reason why people need to avoid frequently trading to a new property right there.

People will usually pay the higher price only if they purchase discount points to minimize their housing debenture rates, which is not an excellent idea unless the buyer stays in the house for a long time. But even with a lower 3{f81c16c78281d5946402c9908c3cc93ce8a08e00599b0629d895a059cbc63ad3} figure and purchase of a $220,000 house (assuming a modest 10{f81c16c78281d5946402c9908c3cc93ce8a08e00599b0629d895a059cbc63ad3} DP), they are looking at $6,600 in their closing costs.

The longer people win the property; the more closing costs are spread out in the long run as part of the monthly cost of ownership. Since the FYR is about where people start to create equity more quickly, it tends to be about the spot where people accumulated home equity starts to outweigh added expenses of both interest payments and closing costs, roughly speaking.

Using sweat equity

A reliable way to create equity a lot quicker is to purchase a house that needs some repairs done to it and make these improvements yourself. By doing this, buyers can increase the value of the house, sometimes a lot quicker, depending on the number of repairs and improvements, as well as realize the benefits when selling these properties only two to three years later.

This kind of approach can work if individuals have the knowledge and skills to make most of the improvements or repairs themselves. Borrowers who are knowledgeable about real estate and construction can usually make this work by contracting all these improvements, but the margin of error is a lot thinner there. The more the work people can do by themselves, the less they are paying out of their own pocket. But this approach is not for everyone.