A housing bubble, also sometimes referred to as a “real estate bubble,” occurs when the price of housing rises at a rapid pace, driven by an increase in demand, limited supply and emotional buying.

Another significant cause can be a prolonged period of sub-normal interest rates. Lower rates allow more people to buy, stimulating demand. Once speculators recognize that housing prices are on the rise, they enter the market as well, further driving up demand.

The phenomenon is called a bubble because inevitably, at some point, it will burst. Typically, it bursts when interest rates start to rise again, wiping out demand. This is what happened during the period from 2007 to 2010.

Housing bubble definition

A housing bubble is a market condition in which prices rise beyond what most believe is reasonable or sustainable. One way this might happen is if median home prices rise out of proportion with median household incomes.

A bubble can also form when the demand for housing exceeds the available supply — it typically requires a rapid and unsustainable increase in housing prices in a short period of time. This can create an environment where homebuyers feel as if they need to overpay to get into the market, while sellers feel they can ask top dollar to get out. Eventually, the bubble bursts, and home values plummet.

But there is a critical difference between an actual housing bubble and simply a very hot real estate market. Hot markets are localized and driven by local conditions. Hot markets happen all the time — much of the U.S. has been experiencing one for several years — but bubbles are rare. When a housing bubble pops, the results, which can include plummeting home values and increased foreclosures, can ripple throughout the larger economy.

What causes a housing bubble, and what are the signs?

A housing bubble is often a symptom of artificially inflated prices. There are multiple factors that can lead to that state, including rapidly increasing demand and a lack of supply to meet that demand. Other possible factors include low mortgage rates, loose credit standards and widespread investor speculation.

It can often be a vicious cycle: Low rates lead to increased buying, which leads to decreased supply, and so on. It can take a while for real estate supply to react and add inventory — depending on the market, it simply may not be possible to add sufficient inventory to meet demand. Add real estate investment firms and professional house-flippers to the equation, and the typical homebuyer can find themselves priced out of the market altogether.

What happens when the bubble bursts?

If a housing bubble is similar to a balloon, then all it takes is one prick to deflate it. Housing bubbles can burst for many reasons, but a sudden rise in interest rates is usually the culprit.

When a bubble pops, it can have dire consequences for homeowners, investors and the overall economy. When property values plummet, banks and other lending institutions can be left in the lurch on mortgages for homes that are no longer worth the price paid, or the amount loaned. This may cause banks to tighten lending for both consumers and businesses, resulting in a general credit reduction — which, in turn, helps to depress economic activity overall.

In addition, if values fall drastically, homeowners face a struggle as well. If buyers overpay during a bubble’s inflated prices, and then prices drop, they run the risk of finding themselves “underwater.” A mortgage is considered underwater when the value of the home has dropped below the amount of the loan — in other words, the homeowner now owes more on the mortgage than the home is worth. ​​Homeowners who are underwater are also referred to as being in a negative-equity position — it’s one of the most common consequences of a housing bubble.

The financial crisis of 2007-08

The bursting of a housing bubble often has a brutal effect on the economy, since the housing market is a major economic driver. It could be followed by a recession or, in severe cases, even a crash.

The financial crisis of 2007–08 was related to the bursting of a real estate bubble that began during the 2000s. Housing prices had peaked in early 2006, and started to decline in 2006 and 2007 when the Fed started raising rates. Then, on December 30, 2008, the Case-Shiller Home Price Index reported its largest price drop in its history. Many homeowners couldn’t pay back their loans, leading to defaulted mortgages and millions of foreclosures. The economic crisis that resulted from this burst bubble is commonly referred to as the Great Recession.

Are we in a housing bubble in 2022?

Housing bubbles are often associated with low mortgage rates and a large number of first-time homebuyers. Sound familiar? It’s no wonder many people are asking whether we’re experiencing a housing bubble in 2022.

However, most experts and economists agree that the market is not heading for a bubble burst, as it did during the early 2000s. While the housing market certainly remains hot, there are several reasons why experts do not forecast an impending crash. These include continued high demand, low inventory levels (though housing inventory is slowly rising) and much stricter lending standards than were in place then.

These stricter loan standards may reduce the number of foreclosures. However, if we wind up in a recession, many people will likely lose their jobs and not be able to make their mortgage payments. If this comes to pass, tougher loan standards may have little effect.

What should you do in a housing bubble?

If you’re a homeowner during a housing bubble, you may see your home’s value skyrocketing — on paper, at least. If you’re tempted to cash in and sell your house while you can get top dollar for it, make sure you have somewhere else to live before you jump into the fray. A seller’s market is great for sellers, but if selling means you then have to buy a new home to live in, you’ll experience the other side of things too.

If you’re one of the many people hoping to buy a home, a bubble may not be the best time to shop. If you have the luxury of staying put and waiting it out, that might be a good option, and your patience will likely be rewarded. If waiting isn’t an option, be sure to do your research before putting in an offer on a home whose price may be over-inflated. An experienced local real estate agent can help you determine what’s best for you — and maybe even find you a hidden gem in a crazy market.