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Ways to protect yourself

There’s lots of talk about whether globally we are expe­riencing a property or real estate bubble. What is a real estate bubble, and how could it affect you?

What is a Real Estate Bubble?

A real estate bubble occurs when housing prices rise rapidly. In a regular market, prices rise in line with the rate of inflation or the rise in average incomes. When the bubble bursts, housing prices tumble, causing the housing market to collapse. In a real estate boom, the cycle runs its course and a market correction takes place more gradually. Prices eventually settle down to more realistic levels.

What Causes a Real Estate Bubble?

There’s heated argument among experts about whether we’re in a real estate bubble or a real estate boom. Ei­ther way, the rising cost of housing encourages people to take on risky debt. Falling interest rates have fuelled the current bubble (or boom). Higher priced houses are now more affordable, inspiring homebuyers to take out larger mortgages or longer payment options. In some cases mortgages exceed the value of the home. This places homebuyers at extreme financial risk, par­ticularly if interest rates rise rather than fall.

How Does a Real Estate Bubble Affect Me?

The rule of thumb that your total housing expenses should not exceed 25 percent of your gross monthly income has been ignored in recent years. Recent Hous­ing Policy reports show that over 40 percent of work­ing families are paying more than 50 percent of their gross income for housing. How much are you paying as a proportion of your income?

The people most at risk are those with adjustable rate mortgages. As interest rates rise, many people 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 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:

  • Don’t overextend yourself.
  • Follow the rule of thumb that you should limit your housing costs to between 25 percent and 32 percent of your gross income.
  • Don’t assume that your house will continue to ap­preciate at the fast pace that it may have in recent years.
  • The more property prices rise, the less likely they will continue to do so.
  • Don’t buy a house you can’t really afford just because you think it’s a good investment.
  • Don’t indulge in cash-back refinancing and use the equity in your home to buy cars or boats, take holi­days or pay off debt (unless you’re committed to avoiding the spending habits that got you into debt in the first place).

The bottom line: don’t panic about a potential real estate bubble, but exercise caution and good financial judgment when buying property, choosing your mort­gage type, or when taking equity out of your home.