Housing Bubble: What Is It, and Are We In One?

The hallmark of a housing bubble is a rapid, constant spike in home prices to the point where homebuying becomes unaffordable. When the bubble eventually “pops,” prices plummet, as was the case during the Great Recession of 2007-09.

Since economic pundits can’t typically confirm a housing bubble until it bursts, it’s important to understand the warning signs and learn how to adjust your buying, refinancing or selling plans accordingly.

What is a housing bubble?

A housing bubble happens when consumers pay more to buy a house than they normally would because they expect large price increases later. This behavior catches on with other homebuyers, effectively inflating the bubble. However, housing experts can’t actually verify a housing bubble until the air starts letting out, which means home prices have to fall before a housing bubble is “official.”

What causes a housing bubble?

The biggest driver of housing bubbles is the fear of missing out (FOMO). Homeowners worry they won’t get a chance to pocket a large pile of cash from selling their homes. Homebuyers panic because prices are heading up and they don’t want to overpay in the future. As more consumers buy into these mindsets, air is pumped into the bubble.

Just because house prices are rising in your area doesn’t necessarily mean your neighborhood is headed for bubble trouble, though. There are other basic economic reasons local home prices may be headed up.

Income growth. It’s normal for house prices to rise as earnings rise. A company may open up a large office with jobs that pay more than other nearby companies, creating demand for homes for the new employees. Residents who couldn’t afford homes at local wages may suddenly make enough to afford more expensive homes, and as new homes are built to meet their needs, home values start to rise.

Falling interest rates. Low mortgage rates translate to lower monthly mortgage payments. As a result, homebuyers can qualify for higher loan amounts and buy more expensive homes, which helps push prices up.

Flexible financing options. Homebuyers may opt for low-down-payment mortgages, convinced they’ll have enough equity to sell at a profit as home prices continue their ascent. However, if the market turns and they have to sell quickly, they may not have enough equity to cover the costs of selling the home and paying off their loan balance.

Housing supply. When there aren’t enough homes to match the number of qualified buyers, competition for available homes heats up. That creates price competition as buyers try to outbid each other to become homeowners.

Signs that a housing bubble is bursting

Although the housing market may not be showing signs of a bubble burst at the national level, real estate is local, which means you should keep track for signs of a housing market downturn.

Some of those signs include:

More expired listings. If homes are staying on the market longer in your neighborhood or listings are expiring, that could be a sign that your market is beginning to soften.

Stricter lenders. If lenders see evidence of weakness in the job market and incomes or anticipate home values may drop, they may set higher standards for mortgage preapproval. They may also raise standards for home equity loans or stop offering them altogether, because of the risk that buyers will default if home prices drop significantly.

Creative financing from sellers. Home sellers may become private lenders offering owner financing and lease purchase options to motivate buyers who don’t qualify for more stringent mortgage bank programs.

Mortgage and real estate layoffs. When the housing market cools off, mortgage and real estate companies can’t justify a large sales force and may start cutting staff. If info about those cuts starts showing up in the news, chances are good the bubble is starting to deflate.

Are we currently in a housing bubble?

There is some evidence that the housing market is displaying “abnormal” behavior that resembles the bubble in the early 2000s, according to a recent report by the Federal Reserve Bank of Dallas.

One bubble pattern economists and investors track is the price-to-rent ratio. When the ratio is high, renting is more cost-effective than buying, which is a red flag that a home bubble is growing. Another closely watched factor is the price-to-income ratio, which ties home prices to disposable income. Although it’s on the rise, it’s not setting off the bubble alarm yet.

How to weather a housing bubble

If you plan to live in your home for the long haul, a housing bubble won’t have that big of an impact on you. However, if you have buying, refinancing or selling plans for the near future, there are some things you can do to protect your equity.

Housing bubble buying tips

• Avoid bidding wars unless you have long-term plans to live in the home
• Ask the seller to pay closing costs — they may be more accommodating as prices drop
• Lock in your interest rate as soon as you can

Housing bubble refinancing tips

• Try not to tie up your equity up with a cash-out refinance, home equity line of credit (HELOC) or home equity loan
• If prices drop significantly, find out if you’re eligible for an underwater mortgage refinance
• Work on paying off your loan balance faster
• Consider a 15-year mortgage term to build equity quicker

Housing bubble selling tips

• Watch for houses staying on the market longer, and be willing to adjust your price
• Talk to your real estate agent about strategies for your area if you notice home prices are dropping
• Offer to pay your buyer’s closing costs