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| The Basics | 5 ways to protect yourself from a housing bubble
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Get past the 'my home is an investment' mentality. Youre in it for the long haul.
By Bankrate.com
The 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."
We cannot ignore the potential for a housing bust any longer. Like procrastinators in a hurricane-prone area who eventually scramble for supplies as a storm nears, it is time to look at some strategies that homeowners and home buyers can adopt to weather a storm in the housing market.
If you live in Ohio, you're probably wondering what all the fuss is about. But in California, New York, Massachusetts, South Florida or Washington, D.C., this is all anyone talks about. If you call one of these or other frothy markets home, unless you've lived in your house long enough to pile up substantial equity, you have reason to worry.
Dont touch the equity
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 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 a 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 it provides will be invaluable when house prices decline. The bottom line on debt consolidation is: it just shifts the debt, it doesn't reduce it. If you managed to get yourself in a little too deep with credit cards, it's time to figure out how to get out of it -- without relying on home equity borrowing.
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Build up equity
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 payment should go toward reducing the principal on your loan. If it isn't, you're doing something wrong. This leads into my next point.
Making steady progress on paying down the balance depends largely on having a fixed-rate loan.
Therefore, we have rule No. 3: It is time to move away from adjustable rates.
There is nothing worse than facing an increasing payment as the value of your home is declining. This means you must refinance out of the short-term adjustable-rate loan that pressures your budget and retards the process of building equity. Get 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 can insulate buyers with equity from a previous home. Small down payments and large loan balances increase the likelihood of relying on interest-only loans.
So, the message to first-time buyers, and rule No. 4, is this: Make a larger down payment.
Think long term
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. Prepare to do the same with a new-home purchase.
If you anticipate moving 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. Any price downturn 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 worries about a bursting bubble.
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MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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