When This Thing Happens, the Housing Bubble May Be About to Burst

A mature couple goes over financial paperwork at home.

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Here's how the rental market impacts the home-buying market.

Key points

  • The more expensive rentals become, the more people who would rather buy a home.
  • Economic trends are cyclical, so keep an eye on the rental factor.

While rising interest rates have reduced the number of bidders on homes in some areas, the housing market remains red-hot. Not only are home buyers paying over asking price in most markets, they're also waiving home appraisals and inspections. While it's easy to declare that this level of over-enthusiasm is unsustainable, it is impossible to say when it will end.

That's why we've turned to the past to look for clues, for a pattern of some kind that would signal an upcoming bubble burst. And here's what we found.

The ‘usual suspects’ still make a difference

When it comes to housing prices, history shows us that several factors play a role:

  • Rising interest rates: The higher the interest rate, the less people can afford to borrow.
  • A national economic downturn: When people are losing jobs with no hope of returning to work soon, there's naturally less interest in taking out new mortgages.
  • An influx of new properties: As more houses hit the market, fewer people battle to buy the same homes.

Two out of three aren't helping

Of the three usual suspects, only one is currently in play -- rising interest rates. Despite inflation caused by the global pandemic and war in Ukraine, the U.S. economy is steaming along, and job creation is strong. More people have the money to buy a home, but too few homes are available.

While we would typically expect housing prices to decrease as interest rates increase, that's not happening now. And it can probably be traced back to the strong economy and hordes of people who want to buy the few homes available.

Those buying today should do so knowing the home they're bidding on could rapidly lose value. If the market bursts or slowly returns to pre-pandemic values, anyone who overpaid for a house recently is likely to be left owing more on a property than it's worth.

What is the precursor we should look out for, the clear sign that home values will soon soften?

Watch the rental market

Let's say someone wants to live in a particular neighborhood. They like everything about it, from how close it is to entertainment venues to the strength of the local school district. They're watching the budget, saving for a rainy day, and don't want to be house poor.

There are two homes available in the neighborhood. One is for sale, and the other for rent. Each is worth around $400,000. Property tax runs $6,000 per year, and homeowners insurance costs $1,200 per year. At this point, it's all about the math.

Imagine that our fictional person has saved $60,000 to buy a new home. They have just enough to pay 10% down, closing costs, and moving expenses. If they decide to buy a home and take out a 30-year fixed mortgage at 5.5%, their total monthly house payments will be $2,794. Of course, they'll also have the added expenses of maintenance and repairs.

Say rental values are stable, and they'd have to pay $2,200 to lease a home in the same neighborhood. Chances are strong that's what they'll decide to do. After all, they'll save money each month, and if anything breaks, the landlord pays to make repairs.

However, if renting the house is $2,700 or $2,800 per month, our character is likely to decide buying is the smart move. That's one more potential home buyer, one more person driving up real estate values.

The reasoning

When it's less expensive to rent than to buy in the same neighborhood, people are more likely to rent. As rental prices climb, a more significant number of people look to take out a mortgage. For some pushed toward buying a house, it's about the security of knowing how much their mortgage payments will be for the next 15 to 30 years. For others, it's the knowledge they could be building equity for the same money they're paying for rent.

Keep your eye on the rental market

A quick online search of "rental market in " offers a snapshot of what's going on in the area where you would like to buy. If you check out the trend over time and rents are softening or holding steady, you can expect housing prices to creep downward. If area rents are climbing quickly, there's bound to be an influx of more people in the home-buying market. And as we've seen over the past 24 months, the more people clamoring for the few houses available, the more expensive those homes become.

We want to add a quick word of encouragement. We can look at historical trends because nothing is new under the sun. Home prices increase, and they decrease. Interest rates rise, and they fall. If your dream is to own a home, it can happen. We won't always be caught in this vortex of ever-rising home prices. At some point, things will even out, and we'll have plenty of houses on the market from which to choose. It's then that prices will drop.

Our Research Expert