The housing market's future has weighed heavily on Americans' minds lately. Statistics for home sales show large declines, and median home prices have begun to fall substantially in major real estate markets nationwide. Homebuilders such as KB Home
After years of stratospheric home prices, it may be a bit wrenching to confront the hard realities of economic cycles. Just as the stock market declines that began in 2000 took investors by surprise, many homeowners have become accustomed to the benefits of rising home values, including the opportunities for cash-out refinancing and other uses for home equity.
If you're prepared, however, falling home prices aren't always a bad thing. While those who are completely dependent on mortgage financing to own their homes may find themselves with fewer options, those with other assets may be able to use falling prices as an opportunity to find a better home.
Lack of liquidity
Falling home prices' biggest impact is their reduction of the average household's liquidity. During the long climb in housing prices over the past decade, many American consumers repeatedly took advantage of increasing property values to pull money from their homes for all types of expenses. Some economists argue that homeowners' ability to tap their rising equity through loans and mortgage refinancing significantly help the country avoid recession over the past several years. As home prices peaked and flattened, many homeowners have found it increasingly difficult to increase the amount of credit tied to their homes. In addition, rising interest rates have made some loans more expensive to manage, pushing homeowners toward retiring debt rather than obtaining new debt.
If housing prices fall dramatically, the effect on household liquidity will be even more pronounced. Unless financial institutions further loosen their lending standards, falling property values will prohibit many new home equity loans and cash-out mortgage refinancing. In addition, homeowners who stretched their credit to the limit in order to buy their homes will find that they have negative equity in their property. That will effectively prevent them from moving until they have enough cash to make up the shortfall between what a buyer would pay and what they owe on their loans.
Opportunity to trade up
In an environment with falling housing prices, cash is king. Cash grants you a number of options that most homeowners lack. Even if the value of your home falls over the coming months or years, cash gives you the flexibility to move if you want. Indeed, if home prices fall across the board, moving may be an attractive proposition in the long run.
Over their lifetimes, most homeowners follow a predictable path with their housing. As young adults, they rent until they can afford to buy a home. Their first house is generally a modest starter home, which suits their needs until they decide to trade up to a larger home. They may repeat this process a few times, until either their children grow up and leave home, or they decide to retire. At that point, they may decide to downsize to a more modest home again, since they live on their own and no longer need extra space.
As a result, most people aren't helped or hurt by changing home prices as much as they might think. Consider, for example, the point at which you decide to sell your starter home and trade up. If prices have risen since you bought your home, you'll make a nice profit when you sell, but you'll also pay a pretty penny for your larger home. Conversely, if prices have fallen, you might lose money on your starter home, but you'll be buying the larger home at a bargain price. In the long run, you might be much happier suffering a loss on your starter home in exchange for perfect timing on your new, larger purchase. However, if you don't have the cash to deal with that loss, you won't have that option; you'll have to stick with your starter home until you've paid down your mortgage enough to let the sales proceeds cover the rest.
The value of financial independence
Falling home prices show one of the advantages of keeping your financial house in order. If you live paycheck-to-paycheck, in debt up to your eyeballs, you have no leeway for things to go wrong. An unexpected layoff, rising mortgage or credit card payments, or even a freak occurrence like a car accident or repair problem can send you spiraling toward financial ruin. With no margin for error, you must do everything right.
On the other hand, making prudent financial decisions leaves you better prepared for occasional problems. An emergency fund gives you security if you lose your job or have a surprise expenses. Keeping your credit under control, and backing up your financial plan with an investment portfolio, lets you think of housing both as an investment and a lifestyle choice. It also lets you freely take advantage of changing market conditions. And best of all, it just feels good to be financially secure.
Falling prices may have a big effect on many homeowners. But if you have your financial house in order, you probably won't feel the hurt, and you may be able to turn bad market conditions to your advantage.
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Fool contributor Dan Caplinger is finally buying a house, so you can be pretty confident that the top is in. He doesn't owns shares of any of the companies mentioned in this article. The Fool's disclosure policy keeps you covered.