For years, buying real estate has seemed like a "sure thing" investment. In many parts of the U.S., housing prices have gone up more than 70% over the past five years, and in a few red-hot markets like Southern California, home values have more than doubled. Suppose you bought a home four years ago for $250,000 and financed with a $200,000 fixed-rate mortgage at 7%. If the market in your area has since climbed 15%, your home is now worth $287,500. You'd have paid only about $9,000 in principal while building over $96,000 in equity. Industry experts disagree on the subject, but many caution that the housing "bubble" may burst soon, causing home values to decline. Should this occur, some of your equity could disappear. And, if you're a recent buyer who bought your home with a low down payment, you could find yourself with a mortgage that exceeds the value of your property. You cannot control home prices, but you can protect yourself from a potential downturn in the real estate market. Just keep these strategies in mind: Avoid buying "too much house" When mortgage rates are low, it can be tempting to make a low down payment or buy more house than you can afford. However, this approach leaves you vulnerable if the market turns, since your equity is low to begin with. Maintain a reasonable loan-to-value ratio Your mortgage principal, plus any outstanding home equity loans, should total no more than 80% of your home's current value. Not only will this get you a better loan rate and eliminate the need to pay Private Mortgage Insurance (PMI), but it also builds in a healthy cushion if the value of your home drops. Stay put Homebuyers may get into trouble if they plan to sell within a year or two, since they're not allowing for the market to recover, should it drop. Staying in your home for at least five years improves your chances of weathering a potential economic storm. Keep an equity stake A home equity loan (HEL) can be an affordable way to consolidate debt, finance renovations, or cover large expenses like college tuition. However, stretching your home equity too thin is risky, should the market head for a downturn. If you expect housing prices to cool off in your area, avoid using a home equity loan to pay for luxuries like a new vehicle or an expensive vacation. Use common sense when cashing out Some homeowners dip into their home equity when refinancing by drawing cash out, resulting in a higher principal on the new mortgage this is called a refinance cash-out. However, just like taking out a home equity loan, this is riskier in the event of a housing market downturn. Build equity faster The less equity you build in your home, the more you could be hurt by a market decline. Interest-only mortgages and option ARMS are higher risk, as they do little or nothing to reduce your principal balance. If you're buying or refinancing and are worried about a downturn (and can afford the higher payments), consider a fixed-rate mortgage with a 15-year term. This will enable you to pay down the principal and build equity much faster. Finally, remember that your home's value is most important on the day you buy and the day you sell. On all the days in between, modest swings in the real estate market shouldn't cause too much concern.
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