Protect Yourself from "Bubble Trouble"

A real estate bubble occurs when housing prices take an unhealthy climb instead of rising gradually with the rate of inflation or the rise in median incomes. The problems arise when the rising cost of housing encourages people to take on risky debt. Fueled by falling interest rates, which makes higher priced houses more affordable, many homebuyers are willing to take out second and third mortgages and variable rate loans. Some folks even make grossly unwise decisions, such as taking on terms longer than 30 years,mortgages that exceed the value of the home, and interest-only loans,placing these homebuyers at extreme financial risk.

Why are these decisions so risky? When the bubble bursts, housing prices tumble,causing the real estate market to collapse, often followed by a recession in the area. (Conversely, in a real estate boom, the cycle runs its course and a market correction takes place more gradually,with prices settling down to more realistic levels.) A general rule of thumb has always been that your total housing expenses, including principal, interest, property taxes, and homeowners' insurance, should not exceed 25% of your gross monthly income. Recently, this rule has been tossed aside. The Center for Housing Policy reports that in the last five years the number of working families paying more than 50% of their gross income for housing has jumped by 76 percent.

The problem with spending so much on housing, is the tendency to resort to using credit cards to pay other expenses. Many people feel confident financially because their home is appreciating in value, but in reality, they're paying outrageous interest rates on credit card debt. This debt is greatly increased when making minimum payments for many years.

Those most at risk are those with adjustable rate mortgages who will not be able to afford the rising payments. As interest rates rise, the hardest hit will be folks who purchased a home they couldn't really afford by getting an adjustable-rate mortgage with low monthly payments. As home prices fall, they may find they owe more than their house is worth and they may be forced to sell, perhaps at a loss. Some sellers may not be able to pay off their mortgage if the balance is more than they'll get for the house. Sadly, some folks will be forced to default and walk away from their home, ruining their credit for many years.

Who's most at risk from a "Busting Bubble"?

Equity is the difference between what you owe on the home and what it's worth.Let's say you purchased a home by using a no-down or low down payment loan to finance it, or you obtained home equity loans and used the cash to make purchases that weren't associated with increasing the value of your home. Both scenarios leave you with little equity. If the real estate bubble bursts, it may result in your having negative equity,where you owe more for the house than it's worth.

That might not be a problem as long as you don't sell until values come back up--and they probably will in time. But if you have to move while values are down it might be difficult to pay your mortgage and closing costs and still have enough left over to buy a replacement home in your new location.

Home Owners with Adjustable Rate Mortgages

If you chose an ARM for its lower initial payments because you knew you'd move before the first rate hike, and the bubble bursts, you may not be able to make those higher payments until property values come back up. Interest-only loans create the same problem if it's time for the interest and principal payments to kick in. Initially, they don't provide any required payment to lower your principal.

If you have negative equity it might be more difficult to refinance in order to switch loan types.

Home Owners Who Must Move

If you have good equity in the house, then you can probably sell with a profit. If you have high equity after living in a home for some time, you may be sorry you didn't sell when prices were high, but you can still typically sell without a loss. However, if you made a hefty down payment, and bought during bubble growth, you will take a hit if you can't wait for values to come back up.

How do you protect yourself from "Bubble Trouble"?

To protect yourself, follow these common sense tactics:

• Keep your overall debt load as low as possible to help you manage an unplanned move.
• Use equity funds to increase your home's value, not buy luxury items.
• Purchase a home with good resale potential.
• Pay attention to your local market. Watch sales trends and read what your local and regional experts have to say about a potential real estate bubble in your area, but keep in mind that even the experts don't agree on where,when--or if--the bubble will burst. If it does, just hang in there,because over time real estate is a great investment. Prices will rise again.
• Don't overextend yourself. Buy a house that you can afford with a traditional mortgage where you make principal and interest payments at a fixed interest rate.
• Follow the rule of thumb that you should limit your housing costs (including property taxes, principal and interest, and homeowners' insurance) to between25% and 32% of your family's gross income.
• Don't assume that your house will continue to appreciate at the fast pace that it may have in recent years.
• Don't buy a house whose price is artificially inflated just because you're afraid you'll miss out on the opportunity to buy before prices go up yet again.
• Don't buy a house you can't really afford just because you think it's a good investment.The more real estate prices rise, the less likely they'll continue to do so. Eventually the bubble will burst, and you don't want to be caught in "bubble trouble."
• Don't indulge in cash-back refinancing and use the equity in your home to buy cars or boats, take vacations, or pay off debt (unless you're committed to avoiding the spending habits that got you into debt in the first place). It could come back to bite you if real estate values decline.
• Don't purchase real estate with an interest-only loan if you can't afford the property otherwise. These loans usually have adjustable interest rates, which could make your payments unaffordable. Once the interest-only period ends and you must start paying principal as well as interest, you may not be able to make the payments and could be forced to sell the property at a loss.
• Choose a modest home in a good neighborhood rather than buying a home larger or fancier than you need or a bigger home in a less desirable neighborhood.
• Avoid buying a house in an area that has appreciated well above the average rate of appreciation in that area over the past few years.

The Bottom Line: While there's no need to panic about a potential real estate bubble, it's best to always practice good financial sense. Exercise caution and good judgment when buying real estate, choosing your mortgage type, and taking equity out of your home. As the saying goes, if it seems too good to be true, it generally is.