Home values have been rising rapidly throughout the pandemic. This has occurred as mortgage rates have hit record lows and the supply of properties has been constrained because many people haven't been listing their houses while COVID-19 has been surging. Although mortgage rates have gone up considerably this year, this hasn't done much to cool the market, which has led some to believe that there's a housing bubble.
Whether the market is indeed in a bubble or not, it's undeniable that home prices are high right now and that many homeowners have substantial equity in their current properties. When these conditions were present in the recent past leading up to the 2008 housing market implosion, many people made some big financial mistakes. Homeowners should aim to avoid these errors this time around. There are three big mistakes in particular to steer clear of. Here's what they are.
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1. Tapping into home equity
Many properties owners raided their home equity during the last real estate boom. People borrowed not just to renovate their homes, but also for unrelated purchases such as vacations. Second mortgages were readily available for large sums since property values were going up so quickly, and homeowners rushed to take advantage of the ability to borrow a fortune.
The problem is that taking too much money out of your home is a high-risk move. Not only could you increase the risk of foreclosure because of your additional second mortgage payments, but you could also have a very difficult time selling in the future if property values fall. That's exactly what happened to many people when they borrowed based on their home's peak price and then ended up owing more than the home was worth after the market crashed.
Now, borrowing against your home equity isn't always guaranteed to lead to disaster. Home equity loans are a type of low-interest debt. If they can be used responsibly, they can give you the opportunity to improve your home's value or fulfill other important financial goals such as consolidating debt.
The key is to make sure you leave a large equity cushion in your home so you don't end up owing more than the house is worth even if property values fall. And you'll want to make sure the borrowing is necessary and, ideally, designed to improve the value of your home, since you are putting your house at risk.
2. Buying a house you can't really afford
If you're eager to buy a property and prices are high, you may find yourself applying for a home loan that's a bit out of your budget just because you're so desperate to find a property that's right for you. Sadly, when you stretch to buy a house, you run the risk of becoming unable to make the payments if anything happens to reduce your income or if you face any unexpected surprise expenses.
Stretching to buy a house can also cause problems if an economic downturn occurs. You could see your income reduced and your property values fall at the same time, leaving you trapped in a home that you can't afford and that you can't sell for what you paid for it.
To make sure you don't borrow more than you should, most experts recommend keeping total housing costs to no more than 25% to 30% of your income. Sticking within these guidelines can help you avoid becoming "house-poor" or unable to fulfill other financial goals.
You may also want to "practice" making your housing payments if they are more than your rent. So, for example, if you're paying $1,000 per month for housing now and are considering buying a house that would cost you $1,300 per month, then put that extra $300 per month in a savings account for a few months to make sure you're comfortable not having that extra cash.
3. Taking out an adjustable-rate mortgage
Finally, in the last housing bubble, people were eager to buy homes because they felt property values would rise forever -- and many took out adjustable-rate mortgages (ARMs) in order to do so.
Adjustable-rate mortgages can initially be easier to qualify for, and can make purchasing a house seem more affordable up front. That's because the starting rate is usually lower than the rate on a 30-year mortgage. The problem is that this rate isn't guaranteed for very long -- usually around three to seven years. After that, it can adjust, changing the amount of monthly payments and total borrowing costs.
When you take out an ARM, your rate is generally tied to a financial index such as the prime rate. This means you can try to predict how payments could change by looking at the historical performance of that index. But, of course, you can't be certain what the future holds.
There is, however, usually a cap on how much your rate can increase over time. This cap is commonly around five percent, though, which means that your rate could go up quite a bit. Some lenders have even higher caps. If your rate goes from 3.5% to 8.5%, that would mean paying an extra $320 per month for each $100,000 of mortgage debt you have.
As you can see, if rates rise, your mortgage payments could quickly become unaffordable with an ARM. And if rates are much higher or home values much lower in the future when your rate begins adjusting, you may not be able to refinance to a new loan that's within your price range. So if you are considering an ARM, you'll want to make sure you can comfortably afford even the highest possible payment.
You don't want to end up with a home that's a financial albatross, or facing foreclosure because you stretched too much to purchase a property. Since these are all huge risks during a housing bubble, it's important to do all you can to avoid falling into these traps to avoid putting your long-term financial situation at risk.
