Great Advice on the Housing Bubble

November 1, 2005

Greg McBride has some great advice about the possibility of getting caught in the crash of the housing bubble here in California. Here are five things that will protect you:

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.



  1. Very, very good advice; thanks for passing it on.

    I got an offer on my condo today — the first day it was available for showings — and accepted it. I’m relieved that I won’t have overlapping mortgage/rent payments. I’d already decided that renting was going to be a better way for me to live in a larger home, pretty much for exactly the reasons this post describes!

  2. Allison..that is so smart of you. I think the country is in for a few years of downturn in the housing value market. Just as it was good to cash out mutual funds during 2000/2001, so now it is advisable to sell if you don’t have a lot of equity, or hang on for the long haul. You’re definitely ahead of the curve right now.

  3. The problem a lot of people in California are going to have is that we were lead to believe that there would be no “bubble” and that we could continue to find equity while paying low monthly payments. If I had to go to a fixed-rate mortgage right now, I would not be able to afford to live here. What can I do?

  4. I think praying about it first might be in order. Second, following Allison’s example might be the ticket. Selling now and renting until you can afford to move into the home market with more substantial means is the best way to make sure the “Bubble” doesn’t burst on you.

  5. I just read in this morning’s paper that Sacramento has seen a 40% downturn in new home sales in the last quarter. This is definitely a bubble bursting I’m afraid. For those who were thinking of using short “ARM” loans, please rethink your position.

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