Is Buying a Smaller House a Good Idea?

a SMART MONEY CONCEPT
Is Buying a Smaller House a Good Idea?

What if you are forced to buy a smaller house because of higher rates...

Between 1987 and 2007, the Return on housing ownership has been close to 184% percent [9.2% percent a year].

2007 to 2012, real estate values dropped 27% from the peak [5.4% per year].

2013 – 2023, real estate values increased by 109% [10.9% per year]

Thus far, only one period longer than 12 months has passed since housing prices went down. We saw the big peak in 2006–07 that bottomed in 2012 and was fully recovered by 2018, our most recent pullback lasted less than 12 months before largely recovering all losses.

Essentially, housing usually goes up, and when it goes down, the big headwind is usually recession (or higher interest rates)... So far, we have had higher rates but no recession.

We know historically, interest rates are back to the historical average of around 7.25%... but using the chart below, we can see how interest rates do impact affordability.

Someone with a $2,000 budget for monthly mortgage payments could buy a $400,000 house at 3.5% (see the graph for assumptions), but if rates are 7% they are going to have to:

- Drop their buy to $300,000 house to keep that same payment.

- Spend about $700 more to buy that same house.

These are the real decisions, but a couple of thought experiments when thinking of buying a smaller house is a good idea:

• If someone bought a house for $300,000 instead of renting at the same rate, they might consider 4% annual appreciation (less than what we've seen historically), the $300,000 X 4% = $12,000 per year + or $1,000 per month positive wealth impact.

• If someone bought a house for $400,000 instead of renting at the same rate, they might consider 4% annual appreciation (less than what we've seen historically), the $400,000 X 4% = $16,000 per year + or $1,333 per month positive wealth impact.

TIP: When comparing the house to the final cost of housing, consider the real impact of appreciation on wealth. A consumer should not buy a house they can't afford, but compared to renting, appreciation is a consideration that works for a buyer after purchase to offset costs but hurts a buyer waiting for a purchase.

BONUS TIP:  My personal recommendation, if I were talking to a relative, would be to buy the smaller house at $300,000 and see if it can work for you. Know that your $2,000 budget is a worst-case payment, and get that potential appreciation working for you... if rates come down from 7% to 3.5% again, your house value will move higher, AND you can refinance and drop your payment to $1,450 a month - or use your appreciation and the lower rate toincrease your buying power with the confidence you can handle it.