Downsizing Your Home to Reduce Debt

If you’re in over your head with credit cards and unsecured loans, a number of strategies can provide relief, such as a debt management plan or an aggressive debt-payoff strategy. But if you’re a homeowner, you might be overlooking one more solution.

The answer to your debt woes may be to simply downsize your home.

Downsizing your home means that you trade your present house for a smaller or less-expensive one.  For instance, you might switch over to a condo or townhouse, or you could move to a home similar to yours in a more affordable area of town.

When you downsize successfully, not only do you reduce your mortgage debt by taking on a less-expensive home, you might also have enough cash left over to pay off your other debts, such as a student loan or credit card. Downsizing also may reduce your monthly mortgage payment — that leaves extra cash in your bank account each month to deal with other needs.

» Learn More: Mortgage Assistance and Options to Help with Mortgage Payments

If you own your house outright, selling it and buying a less-expensive one allows you to purchase a new home and pocket the difference.

SmartMoney writer Glenn Ruffenach says the savings that come with a smaller home make long-term sense for many people. For retirees hoping to stretch their savings, it can be a smart retirement strategy, freeing up money so they can live more comfortably.

What Is Required to Downsize?

Downsizing your home is a two-part transaction: You must sell your current property and buy a more affordable one. This requires both a financial and lifestyle adjustment — along with the financial benefit comes the necessity to live much more efficiently.

If you need financing, the process is smoother when you have a strong credit score, preferably over 700. As of 2010, over half of Federal Housing Administration (FHA) borrowers needed a score of at least 680 to qualify for a mortgage loan. Sixty percent of conventional mortgage borrowers had a score of at least 780.

If you have a mortgage balance, and your goal is immediate debt reduction, you also need sufficient home equity — the difference between your home’s market value and the current mortgage balance — to come out of the deal with adequate cash. In a best-case scenario, you would have enough equity in your property to cover the down payment on the new home and also pay off your other debt balances in full.

Potential Challenges to Downsizing

Downsizing your home may seem simple on paper, but you can run into a few obstacles along the way. One challenge may be getting a lender to approve you for a mortgage at a new house while you’re still obligated at the original home. You need a top credit score and plenty of cash to successfully take this route.

If you do not have the necessary credit and cash, an alternative is to close the sale of your current home first, and then proceed with the purchase of your new, downsized home. You can then use proceeds from the sale to put toward a down payment on your new place. In either case it is important to consult with a lender and financial advisor about this move in advance.

Another potential challenge is learning after the official appraisal that your home is not worth as much as you expected. According to CoreLogic, a mortgage data company, 11.1 million borrowers were under water — meaning they owed more on the mortgage than the home was worth — as of the end of 2011.  Homeowners in this situation still might find it prudent to downsize but it may not do much to improve your overall debt situation in the short term.

If you’re under water on your mortgage, see if your lender will agree to a short sale in which you will not be responsible for the difference between the selling price and the mortgage balance. A short sale is often more advantageous for a lender than a foreclosure. According to Glenn Kelman, founder of online real-estate brokerage Redfin.com, “The lenders lose 50% on a foreclosure and only 30% on a short sale.” Hire a lawyer if necessary to negotiate the process so that you can move into your new place without a major hit to your credit.

Also, if you won’t have the cash available to purchase a new, smaller home, consider downsizing to apartment living instead.

Making a Plan of Action

Now that you have a fuller picture of how to downsize your home, you’ll need a plan of action. Start by compiling a to-do list, along with a realistic timeline for completing each transaction.