Buying a house? The 5-year rule

When looking to buy a house you should ask yourself how long you are likely to stay in the house. Of course, most people don’t know these sorts of things for sure, but generally it is a good ide to make sure that I’d own the house for at least five years.

The Upgrade Cycle

Many first-time buyers will buy a townhouse or a small house 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, by three years out you’ll be in a position to afford a bigger house. And everyone assumes that buying is more cost-effective than renting — as long as you’re paying down the capital 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 end up losing money.

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. Otherwise, financially, you’re probably going to take a hit.

The first hit is your transfer costs. Every time you buy or sell 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 tens or hundreds of thousands of Rand.  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 bond instalments 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’re getting a better deal than paying 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 capital owed is highest, the interest you need to pay on the capital loaned 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 interest payments, and therefore less goes towards the capital owing. As your debt goes down, your interests payments will go down, leaving more of your payment to go towards reducing the capital owed.

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 still make buying a house that you don’t plan to stay in long-term a good 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, then you can pay off a bigger chunk of the capital. 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. Sometimes it’s possible to purchase a home, start paying it down and fixing it up so that you can move on and rent it out. However, you should be careful that you’re choosing a house that you can afford even if you don’t have a renter, on top of a mortgage for your next home.

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, then you should keep renting until you’re ready to spend at least five years in the same home.

Formula
Here is a quick formula that you can use to help you work out out whether it’s better to buy or sell that works with any duration of ownership.

Try to determine the answer to:
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 + Transfer 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.

Of course, the big question mark is your anticipated selling price, which you will obviously have to estimate. The higher the realistic future selling price is, the more buying makes sense.

Although the five year rule is actually pretty arbitrary, if you assume that the long term trend of property prices is up, buying makes sense the longer you stay in the home.

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