3 Financial Hiccups You Might Face in the Course of Downsizing

If you've been struggling to keep up with your housing costs, you may be considering the idea of downsizing to a smaller place. Downsizing isn't just something for retirees or empty nesters to do. There may come a point when you decide that you're tired of sky-high property taxes and utility bills, and that you'd rather swap your current home for one with less square footage.

In many cases, downsizing a home can result in nice savings. But here are a few financial pitfalls you might encounter in the course of downsizing your home.

1. Having to pay capital gains tax

It's common for home values to rise over time. But if you sell your home at a profit in the course of downsizing, you might owe the IRS a piece of your profit in the form of capital gains taxes. And that could make it more difficult to pay for a replacement home.

The good news is that there's a capital gains tax exclusion for homeowners. If you're single, you don't pay taxes on your first $250,000 in gains. If you're married, that exemption rises to $500,000.

But still, let's say you bought your home for $150,000 a good 20 years ago, and it's now worth $950,000. If you're married, you're still looking at capital gains taxes on $300,000 of that $800,000 profit, which might make it harder to come up with the down payment on your next mortgage.

2. Not being able to find a smaller home due to limited inventory

The National Association of Realtors found that in January, there was only a three-month supply of available homes on the market. It commonly takes up to a six-month supply of homes to meet buyer demand in full.

Because there's not a lot of inventory to go around, you might struggle to find a smaller home that meets your needs. For example, you might have to go outside your current neighborhood, which may not be desirable. Or you might have to give up certain amenities you've come to appreciate.

Another issue you might encounter is having to buy a smaller home that's outdated. If you're forced to sink money into making upgrades, it could eat away at your savings.

3. Paying up for a new mortgage on a smaller home

Mortgage lenders are no longer offering the record-low interest rates on loans that they were a few years ago. Quite the opposite -- mortgage rates are relatively high today, so much so that downsizing may not save you as much money as expected.

The average 30-year mortgage rate as of this writing is 6.9%, per Freddie Mac. But if you bought a home prior to 2023 or refinanced during the pandemic, the rate on your current mortgage may be a lot lower.

In fact, let's say you're paying 3% interest on a 30-year fixed $500,000 mortgage today. That's a monthly payment of $2,108 for principal and interest. If you were to swap that for a $300,000 mortgage at 6.9%, you'd be looking at $1,976 a month instead.

That's some savings -- $132 a month's worth. But all told, you're saving under $1,600 a year. That may not be worth the stress and hassle of moving.

Of course, downsizing could also mean saving on expenses like property taxes and utilities. But still, your overall savings may not be so substantial due to the high cost of signing a mortgage today.

Downsizing your home isn't necessarily a poor choice. For a lot of people, it could make financial sense. Just be mindful of these pitfalls as you weigh your options.