If you are thinking about how to downsize your home, you might be on to something big. It’s often one of the best ways to secure your financial situation. Then again, you could be wasting your time entirely. Let’s explore.
It’s true that maintaining a home is much more expensive than people realize. And the bigger the home, the greater the expense. Beyond the mortgage, taxes and insurance, you have to consider repairs and maintenance. These are all included when you calculate the real cost of home ownership.
That is precisely why more and more people are interested in downsizing their home and or housing expense. They are keenly focused on reducing their financial footprint in order to pay off debt and/or have more freedom.
Neal’s Notes: Sometimes, renovating is cheaper than moving. If you are going that route, make sure to finance those home improvements at the lowest possible cost.
The problem is that many times downsizing doesn’t result in all that much savings. And people sometimes go through all this work only to find their living expenses are about the same as before. What a waste of time and energy.
Here’s how to know if it makes sense to downsize and if so, how to do it right.
1. What does it really cost you to live in your home now?
You might think you know what it costs you to live in your home but if you take a closer look you might be surprised. As I already suggested, there are many expenses associated with home ownership that go far beyond your mortgage. If you have been tracking your spending and categorizing your expenses correctly, it won’t be tough for you to figure this out. Make sure to include gardening, taxes, repairs, maintenance, insurance, taxes and amortized remodeling costs as well.
If you don’t track your expenses now, I strongly encourage you to start doing so. (This is even more important for retired people. That’s because income is fixed but expenses aren’t. And for that reason, retired people have to keep a closer eye on what it costs them to live.)
For purposes of our illustration, let’s assume that your current mortgage payment is $1500 a month. Let’s say that this $1500 includes taxes and insurance. But let’s also assume that when you go back through your spending your realize that you spent an additional $6000 a year (on average) for repairs and maintenance. If that’s the case, it actually costs you about $2,000 a month to live in your home….right? ($6000 divided by 12 is $500 a month. $500 a month for average repairs and maintenance plus the $1500 mortgage payment is $2000.)
2. How much will you really receive if you sell your home?
This step is easy. Talk to a realtor and get data on homes like yours that sold in your neighborhood. If you want to save time, you can get this information very quickly at Zillow.com. Remember that you will incur expenses when you sell your home. You’ll have to pay a commission to your realtor unless you sell your home yourself. On top of that you’ll have moving expenses. Figure 6% to 8% for selling and moving costs.
Finally, there are costs associated with a new home that people often neglect. These include remodeling, landscaping and new furniture. Make sure to consider all these expenses when you make your estimates.
3. How much can you earn on that excess capital?
You’ve already calculated what you can sell your home for. You also know what it will cost you to sell and move. And you estimated how much new house you can afford and what it will cost you to renovate your new home. Let’s just assume that your calculation looks something like this:
The illustration above assumes that you’ll pocket $250,000 when you sell your home after you pay off your mortgage. It also assumes you’ll put $100,000 down on the new home. As you can see, this leaves you with about $114,500 when all the dust settles.
Now the question is how much can you earn on this money. I’ve discussed how to invest to create income many times before. To make a long story short, let’s assume that you could invest this money and withdraw 4% of it each year. That leaves you with about $4500 a year in income or a little less than $400 a month. Let’s keep going.
4. What will it really cost you to live if you downsize?
Let’s assume that the total cost to live in your new home (after you account for the new mortgage, lower repairs and maintenance, property taxes and insurance) is $1500 a month.
But just remember that you are about to make a huge financial move. Are you absolutely certain that your maintenance will decline? Do you really have a good sense of what the new insurance and property tax is going to be? Don’t be afraid to spend as much time as you need to look into all these matters.
Be sure you’ve asked all the questions. This is a great time to consult with your CPA to make sure you haven’t overlooked anything. It’s always a good idea to put an extra set of eyes on a project like this. The last thing you want to do is make this big decision without thinking through everything very carefully and double checking your work.
5. Is it worth it?
Time to get out your calculator. You save about $500 a month as a result of lower housing costs. And you earn an extra $400 on the excess capital you created. That means you’ve created an extra $900 a month (before tax) as a result of this move.
If you were only short by $500 a month, the downsizing might make sense. But if you are short by $1,000, you need to do more because this move isn’t going to solve your problem entirely. You might sell your home and becoming a renter. This would create more capital to invest and potentially much lower expenses too. It all depends on your situation.
The bottom line on downsizing is to look at this methodically. Take your time. Consider all your costs and the realistic net amount you’ll have to invest and earn an income on. Then, make sure that the net savings makes it worth your time.
If at the end of the day you need to create more income, that’s fine. Downsizing might be part of your solution or you might need to downsize differently. But go through this exercise first. It could save you a great deal of time, money and anxiety.
Are you considering downsizing? What other issues are you considering?