Theres lots of talk about whether areas of the US are experiencing a real estate bubble. What is a real estate bubble, and how could it affect you? Is the current housing market in a real estate bubble or is this just a normal housing boom? Learn how you can protect yourself against real estate "bubble trouble."

What Is a Real Estate Bubble?

A real estate bubble occurs when housing prices take an unhealthy climb instead of rising gradually with the rate of inflation or the rise in median incomes. When the bubble bursts, housing prices tumble, which causes the real estate market to collapse, often followed by a recession in that area. In a real estate boom, the cycle runs its course and a market correction takes place more gradually, with prices settling down to more realistic levels.

What Causes a Real Estate Bubble?

Theres heated argument among experts about whether were in a real estate bubble or a real estate boom. Either way, the rising cost of housing encourages people to take on risky debt. The bubble (or boom) has been fueled by falling interest rates, which makes higher priced houses more affordable, and the willingness of homebuyers to take out second and third mortgages, variable rate loans, terms longer than 30 years (unwise), mortgages that exceed the value of the home (if you can believe it), and interest-only loans (buyer beware!). Most of these place homebuyers at extreme financial risk.

How Does a Real Estate Bubble Affect Me?

The rule of thumb that your total housing expenses, including principal, interest, property taxes, and homeowners insurance, should not exceed 25% of your gross monthly income has been tossed aside in recent years. The Center for Housing Policy reports that in the last five years the number of working families paying more than 50% of their gross income for housing has jumped by 76%.

When people spend so much on housing, they are often forced to use credit card debt to pay other expenses. They may feel confident that theyre okay financially because their home is appreciating in value, but in reality, theyre paying often outrageous interest rates on credit card debt and stretching the payments out over many years by making minimum payments.

The people most at risk are those with adjustable rate mortgages. As interest rates rise, many people with adjustable-rate mortgages and low monthly payments that allowed them to buy a home they couldnt really afford will not be able to make the rising payments. As home prices fall, these people may owe more than their house is worth. They may be forced to sell, perhaps at a loss. Where will they get the money to pay off their mortgage if the balance is more than theyll get for the house? Some will be forced to default and walk away from their home, ruining their credit for many years.

How Can I Protect Myself From a Real Estate Bubble?

To protect yourself, follow these simple tips:

• Dont overextend yourself. Buy a house that you can afford with a traditional mortgage where you make principal and interest payments at a fixed interest rate.

   

• Follow the rule of thumb that you should limit your housing costs (including property taxes, principal and interest, and homeowners insurance) to between 25% and 32% of your familys gross income.

   

• Dont assume that your house will continue to appreciate at the fast pace that it may have in recent years.

   

• Dont buy a house whose price is artificially inflated just because youre afraid youll miss out on the opportunity to buy before prices go up yet again.

   

• Dont buy a house you cant really afford just because you think its a good investment. The more real estate prices rise, the less likely theyll continue to do so. Eventually the bubble will burst, and you dont want to be caught in "bubble trouble."

   

• Dont indulge in cash-back refinancing and use the equity in your home to buy cars or boats, take vacations, or pay off debt (unless youre committed to avoiding the spending habits that got you into debt in the first place). It could come back to bite you if real estate values decline.

   

• Dont purchase real estate with an interest-only loan if you cant afford the property otherwise. These loans usually have adjustable interest rates, which could make your payments unaffordable. Once the interest-only period ends and you must start paying principal as well as interest, you may not be able to make the payments and could be forced to sell the property at a loss.

   

• Choose a modest home in a good neighborhood rather than buying a home larger or fancier than you need or a bigger home in a less desirable neighborhood.

   

• Avoid buying a house in an area that has appreciated well above the average rate of appreciation in that area over the past few years.

The bottom line: dont panic about a potential real estate bubble, but exercise caution and good financial judgment when buying real estate, choosing your mortgage type, and taking equity out of your home.