4 Questions To Ask Yourself Before Downsizing Your Home
Accessing The Useless Equity In Your Home
For many people, the majority of their wealth is in their home. If you own a house, mortgage-free worth $1 million you are what I call a “paper millionaire”. On paper, you would have a one million dollar net worth.
I say on paper because what good is it to have an asset worth $1 million if you have to live in it? Having equity in your home is well and good but what does it really do for you?
The equity in your home is probably the most non-liquid wealth you will ever own. Sure you could access that equity by selling your house but then you need to buy another house and either get a mortgage or use your equity on the new home, which would again lock that equity up. At the end of the day, you still have to live somewhere.
The truth is, home equity is about the most worthless form of wealth there is. It produces no income for you and is nearly impossible to access unless you are willing to do one of two things.
- Sell your house and move to a city or town with lower real estate prices or
- Sell your house and downsize to a less expensive home.
Obviously, if you are going to sell your home in New York City for $3 million and buy a home in rural Texas for $150,000, you can convert that useless home equity into liquid investments pretty easily.
If you want to live in the same geographical area you currently live the next best way to access the equity in your home would be to consider downsizing to something smaller and less expensive.
Here are four important questions you should ask yourself before you consider downsizing.
First Question: How Much Living Space Do You Really Need?
If you have even one room in your house that you haven’t spent more than 5 minutes in over the past month, chances are you have more space than you need. If you have bought more house than you need, that hurts your finances in three ways.
- You are paying interest (through your mortgage) and property taxes on space you don’t use.
- Your heating, electricity and maintenance bills will be higher than if you had a smaller house and;
- Since more of your cash is tied up in a house you don’t fully utilize, you have less money to invest in income-producing assets like stocks and bonds.
You also don’t want to find yourself in a situation where you have less house than you need. If you have 5 kids, a wife/husband, a dog, and two cats, you probably won’t be too happy living in a 700 sqft condo.
It’s important to figure out the optimal amount of living space for your particular circumstances.
If you decide you have about the right amount of living space for your current situation, and you can afford to live where you currently are, then your decision is simple. Do nothing.
If you think you might have more space than you need and are considering downsizing the second question you’ll want to ask yourself is…
Second Question: Will You Rent Or Buy?
I know there is still a bit of a stigma against renting. We’ve been told as a society for decades that if you want to be wealthy, you need to own a home. If you are reading an article about downsizing your home, chances are you have been a homeowner for a number of years.
If you’ve built a substantial amount of equity in your home, you have the potential to fully realize all of that equity by selling your house and choosing to rent.
Price to rent ratios
One key metric to help you with the decision whether to rent or buy is the price to rent ratio of your local real estate market. Price to rent ratio is a measure of how affordable it is to rent compared to buying in your city.
Price to rent ratio is calculated by taking the average home price and dividing it by the average annual rent.
If the average price of a home in your city was $300,000 and the average rent was $1,000 per month, the price to rent ratio would be equal to 25 ($300,000÷($1,000 x 12))
Generally speaking, the higher the price to rent ratio the more expensive it is to buy a home compared to renting a home.
If you are a homeowner in San Fransico where the price to rent ratio is 46, you might do well to cash out and rent. A price of rent ratio of 46 means you could sell your house for the equivalent of 46 years worth of rent.
If you live in Detroit where the price to rent ratio is just above 6, you might be better off holding onto your home, because you might not be able to sell it for a lot relative to what you would be paying in rent.
Third Question: Do You Want To Relocate?
I’m not talking about moving from New York City to a rural area. But would you be willing to relocate from the suburbs to downtown? If you move into an urban area with access to a strong transit system, you might be able to move from a one or two car family down to a one or zero car family.
Your car is the biggest money pit you own. Even if you bought too much house, chances are you could sell it for at least what you paid for it. What’s the old saying about a car? It loses half its value when you drive it off the lot.
The major impact a car will have on your finances is how much of your cash flow it takes up. Between gas, insurance, maintenance, payments and interest, the average cost to own a car these days is over $8,000 per year according to AAA.
So if you are a two car family and you could move downtown next to a subway line (or any transit) you could save $16,000 per year.
But there is more to life than money, so if you would be completely miserable living in the city, don’t move there!
Fourth Question: How Much Time And Money Are You Willing To Put Into Maintaining Your Property?
My wife and I have a decent size house with a massive backyard. It is a pain in the ass maintaining it. Mowing the lawn, pulling the weeds, shoveling, raking. It never ends. I don’t really mind doing the work because I am a young man who has not yet started a family. I want my kids to have a big backyard to play in. If that means pulling a few (hundred) weeds each year, so be it.
But I can tell you one thing. When I get old, I won’t be doing it. Maintaining a property is a young man’s game. When I hit 60 (or whenever I start to feel too old) it will be the apartment life for me.
When you own a single family home you can decide you are going to invest one of two things to maintain your property: time or money.
In reality, you’ll end up investing both. But you can save yourself some money by investing the money to have someone maintain your property for you. This is the option most people go for. There is a certain amount of pride in maintaining your own property.
If you are renting or living in a condo, you are trading money for time. You pay rent or condo/HOA fees and someone else will take care of the shoveling, and the landscaping and repairing the roof.
You might end up paying more over time, but when the toilet starts overflowing in the middle of the night it sure would be nice to be able to call a landlord to come and take care of it for you.
If you’re willing to put in the effort to maintain a single family home, then it can be a rewarding experience. If you are not, you are probably better off renting or living the condo life.
So there are my four questions. This is by no means an exhaustive list, but hopefully, this gets you thinking about all the considerations that go into a decision to downsize your home.
Are there any questions that you think I should have asked? Let me know in the comments.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.