Is Buying a Smaller House a Good Idea?
What if you are forced to buy a smaller house because of higher rates...
Key consideration: Appreciation (offsets cost of ownership compared to renting)
Between 1987 and 2007, the Return 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 where housing prices went down. We saw the big peak in 2006-7 that bottomed in 2012, and was fully recover 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.
Key consideration: Interest Rate (impacts affordability when compared to renting)
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 payment could buy a $400,000 house at 3.5% (see 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 thought experiments when thinking if 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 at 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 at 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 house and payments consider the real impact of appreciation on their wealth. They should not buy a house they can't afford, but compared to renting the appreciation is a consideration that works for them after purchase, and hurts them waiting for a purchase.
BONUS: My personal recommendation, if I was talking to a relative would be to buy the smaller house at $300,000 and see if it can work for you, know that you $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 rocket higher because everyone can afford more house, AND you can likely refinance and drop your payment to $1,450 a month - and save all the extra for the future, or you can then buy that bigger house with your appreciation and increase buying power.
Just for fun, calculate the wealth creation over 10 years from the appreciation compared to renting, AND add that to the $700 a month you saved that could be invested by buying the smaller house now.
