K.,
I would say, follow your instincts. I think 5 is definitely too young. I have a 5 year old, and she has talked about it a litle bit, but no one in her preschool group or our neighborhood is actually doing that yet.
This is an area I plan to be pretty strict and fuddy-duddy in, because there are just too many possibilities for bad things to happen. I won't let my girls sleep over at anyone's home for as long as possible. I have a friend whose niece spent the night with a friend from church. The girl's father was a deacon. Well, he exposed himself to the niece! So you really never know what could happen, and even when you think you know someone, strange things occur. And now with internet access, all the TV channels, etc, there are so many more avenues for our children to get improperly exposed to bad things.
My thinking is, if the rule is across the board - you can't spend the night with anyone - then I don't have to explain to my child or to any parents why one family is okay and another is not. I think the 1/2 night plan is a great one for older kids. Hang in there! Our girls are the same ages - aren't they fun? Enjoy them, and I believe you almost can't over-protect your kids! Better to hold your ground than have to try to regain lost ground. :)