Protecting yourself from a housing bubble

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he run-up in home prices in many markets around the country makes it a matter of when and where, not if, the housing bubble bursts. Consider this comment from economist Joel Naroff after new-home sales hit yet another record high in June, “Welcome to our worst nightmare. It is the housing market.”

In that vein, we cannot ignore the potential for a housing bust any longer. Like procrastinators living in a hurricane-prone area that eventually scramble to stock up on supplies as a storm nears, it is time to look at some strategies homeowners and home buyers can adopt to weather the housing market storm.

If you live in Ohio, you’re probably wondering what all the fuss is about. But if you live in California, New York, Massachusetts, South Florida or Washington, D.C. — and plenty of people do — it is all anyone ever talks about. If you call one of these or many other frothy markets home, unless you’ve lived in the home long enough to pile up substantial equity, you have reason to worry.

So let’s establish some frontline defenses against a housing bust busting your financial picture.

First, don’t borrow against home equity. This means no taking out of home equity lines of credit to pay off credit card bills, no cash-out mortgage refinancing to fix up the house, and, by all means, no tapping home equity to pay for summer vacation. This is a drastic measure, I know, but these are desperate times, my friends. Home equity has a much lower after-tax cost than credit card debt or other forms of debt, but the cushion provided by home equity will be invaluable when home prices decline. The bottom line on debt consolidations is that it just shifts the debt, it doesn’t reduce the debt. If you managed to get yourself in a little too deep on the credit card debt, it’s time to figure out how to get out of it. And not by relying on home equity borrowing.

The second rule is to build equity through principal repayment. Interest-only and option ARM borrowers, I’m talking to you. Every month, a larger portion of your monthly payment should be going toward reducing the principal on your loan, and if it isn’t, then you’re doing something wrong. This leads into my next point.

Making steady progress on paying down the balance is largely dependent upon having a loan with a fixed rate. Therefore, we have rule No. 3: It is time to move away from adjustable rates. There is nothing worse than the payments increasing when the value of the home is declining. This means refinancing out of the short-term adjustable-rate loan that pressures your budget and retards the process of building equity through principal repayment as interest rates climb and getting into a fixed-rate mortgage or hybrid ARM where the fixed-rate period is no less than seven years. Why so long? I’ll come back to this point later on.

First-time home buyers are especially vulnerable to a downturn in home prices because of minimal down payments and the lack of established equity that buyers rolling over from a previous home would have. Small down payments and large loan balances increase the likelihood of relying on interest-only loans and the like for affordability. So the message to first-time buyers, and rule No. 4, is this: Make a larger down payment. If you don’t have the scratch for a down payment and you can’t afford to borrow with a fixed-rate mortgage — don’t buy. It’s that simple.

The fifth rule is to live in your home for the longer haul. Whenever you’re upside down on a car because you owe more than it is worth, the cure-all is to literally drive your way out of it by keeping the car until the loan balance falls below the market value. Be prepared to do the same with a new-home purchase. If your feeling is that you’re going to move in three years, it is time to make plans for other contingencies. Can you afford a mortgage that offers a fixed rate for a longer period, such as a 10/1 ARM or a 30-year fixed-rate mortgage? If not, continue renting. The transaction costs of buying and selling are steep, and any downturn in price over such a short holding period will clobber the unsuspecting buyer.

The home is first and foremost where you live. Get past the “my home is an investment” mentality to protect against the bursting bubble. The home is indeed an investment, but a long-term investment. Treating it as such will vanquish many of the worries about a bursting bubble.