When bubbles burst, some win, some lose
When a housing bubble bursts, two things separate
winners from losers: timing and the debt level.
Timing matters because the losers are those who end
up selling their homes after values fall and before prices rebound. The
winners wait longer and keep their homes until values recover. Whether
they feel like winners is another matter: Some people end up financially
trapped in their homes, wishing they could move, but unable to afford
for the debt level: that's a plain-spoken way of referring to the debt-to-equity
ratio. The higher that ratio, the deeper the trouble you can get into. It's safer
to borrow 75 percent of the purchase price ($150,000 for a $200,000 house) than
to borrow 90 percent ($180,000 for a $200,000 house).
The surest protection from a housing bubble is to buy a home
while prices are rising, long before the bubble bursts (in other words, to have
good timing), and to make a substantial down payment and avoid borrowing against
equity (so you don't go too deeply into debt compared to the home's price). In
such a case the home often can be sold for a gain, even after values collapse,
because the rise was bigger than the fall.
Timing is partly out of your control because you can't
dictate when prices collapse. Timing is partly under your control, though,
because you can elect not to buy a house, if you think you would own it
for only a couple of years.
While timing isn't fully under your control, you can manage
your indebtedness. Imagine debt as water that's flooding your neighborhood.
If you make a 20-percent down payment when you buy the house, the water
is just below the eaves. In case of emergency, you can scramble onto the
roof. But then you get a home equity loan worth another 10 percent of
the purchase price. Now only the top of the roof is above the water. In
an emergency you'll sit on the roof's peak as water laps at your toes.
The hard way
Now imagine the house sinking into the ground. That's a metaphor for a
drop in the home's value. Let's say the value drops 20 percent below the
purchase price. The entire house is underwater -- even the top of the
roof where you had been sitting. You owe more than the house is worth.
You'll have to tread water until the value rises again or you can pay
down some of the debt. If you're forced to sell the house while it's underwater,
the buyer will give you less than you owe the bank. You'll have to find
the money somewhere or else suffer a big hit to your credit record.
One way to avoid the pain of a burst housing bubble is
to make a substantial down payment. If you put 20 percent down and the
value has dropped 10 percent by the time you sell it, you'll sell the
house at a loss. Bad luck, but your out-of-pocket expense, even after
paying a real-estate commission, will be minimal or nonexistent. In fact,
you might end up with a few bucks in cash after you sell the house, retire
the mortgage and pay commissions. (This is assuming that you don't take
out a home equity loan.)
On the other hand, if you put 5 percent down and have to
sell the home after it has lost 10 percent of its original value, you'll
have to come up with cash to satisfy the mortgage and pay any real-estate
commissions. Failure to pay off the mortgage in full could result in a
messed-up credit record for years.