As far as size goes you might have to accept that smart phones are big now!
If the high end smart phones are a bit too pricey, I think I can recommend the phone I just got, which is a Sony Xperia M2. It's their mid range phone, apparently not as powerful as the z2, but I don't really play games on it so it hasn't bothered me, and it' near half the price of most high end phones. I'm sure that most games that are really designed for phones would be fine on it. It has one of the better battery lives I've seen in a smart phone - I get about 2 days from it if I'm using it fairly heavily, and if I'm using it how I normally use it (some phone calls, maybe about an hour a day using it as an MP3 player) then I get 3 or 4 before it needs charging. It also has that sweet 4g capability.
For the more general questions, I'm no expert but here's a few thoughts:
On whether it will last for 3 years: My last phone was a Samsung Galaxy S2 which I got second hand from my sister. It lasted me 3 years, and she had it for 2. It still works, actually, but it was slowing down a lot and the OS had developed some odd bugs. Basically there's no reason, imo, that any phone wouldn't last 3 years at least if you take care of it. Obviously with phones getting larger and thinner it's a bit easier to break them accidentally now, but if you're not clumsy then you should be ok!
On whether to buy Sim Free or get a contract: Best thing to do is to compare any contract that comes with a phone to the cost of the phone, and the cost of an equivalent SIM-only contract. If you get a phone on contract (in the UK) it's normally a 24 month contract, so it's a case of subtracting 24 months worth of the SIM-only contract from 24 months of the with SIM contract to find out how much they are charging you for the phone, essentially. It will invariably be over the odds, but that's thee premium for financing your phone I suppose. I suppose this is actually totally obvious, but I feel like in this country they try and obfuscate the fact that what you are doing is financing a purchase. If you have the money in hand, it will almost certainly be better to buy the phone out of pocket and get a SIM only contract. Less money overall, and it will have less impact on your monthly cash flow.
On whether a better phone is worth it over a console: Obviously this is a personal decision, but for me I would say definitely not. The range of types of game you can get on a phone is pretty limited, and honestly once the initial excitement has worn off I very rarely find myself using my phone for games. It might be worth it if you are travelling/commuting a lot and don't get much time to sit down and play games, I suppose.
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