This week ASIC Chairman, Greg Medcraft, released a high-level warning that house prices across Sydney and Melbourne have all the hallmarks of a bubble.
A housing bubble is a heated market with an over supply of buyers. Bubbles are caused by an increase in demand that might be the result of low interest rates or an increase in people’s disposable income. The problem is that, as Mr Medcraft told the AFR, “History shows that people don’t know when they are in a bubble until it’s over.”
Unlike the stock market where investors seem to understand that their stock might fall, people who buy a house often make the mistake of believing its value can only rise. This false sense of security drives them to take risks, often borrowing too high and buying a property worth several times the size of their disposable income.
So what causes a bubble to burst?
A downturn in the economy, or an increase in interest rates can force homeowners who have borrowed too much to default on their repayments. Demand decreases and house prices fall with many homeowners forced to sell at a loss.
How to avoid getting caught in the downhill spiral…
- When deciding how much to borrow, make sure you can afford the loan repayments in the event of a rate rise. Not so long ago, rates climbed as high as 10%, and could do so again. My Rate has a series of calculators to help you work out repayments, stamp duty etc.
- Don’t make the mistake of believing the value of a property can only climb. If you’re buying in an overheated market, assume that house prices will stabilise or even fall at some point. Recent home price performance isn’t a reliable prediction for future home price performance, so always consider long-term averages as an indication for where house prices could end up.
- Consider fixed interest rates that offer peace of mind and the ability to budget accurately for a set period of time. Be mindful that when the fixed period ends, you may need to adjust your budget considerably if variable rates have risen.
- Be wary of panic selling. If you prepare for the worst well in advance you should avoid having to sell at a loss. Keep repayments as high as possible while interest rates are low and build a redraw facility you can draw from to cover any increases in the event of a rate rise.
- Regularly monitor the market and watch out for signs of change. Read real estate news from trusted sources and pay attention to the warnings. If you’re anxious about the value of your property in the event of a bubble burst, you may be able to sell before prices fall.
- If you’re an investor, try not to get over greedy. Staying in a red hot market ‘til it peaks is dangerous and risky. When a market drops, it can happen quickly bringing huge financial losses. Evaluate the risks and, if necessary, find an honest broker or buyers’ advocate who can read the signs and give you accurate, trusted advice about buying and selling.
- In his warning, Greg Medcraft was particularly concerned about “the self-managed super sector being exposed to a correction in prices”. If you’re considering investing in property through a self-managed super fund, make sure the property you buy is not the only asset in your portfolio. The key to a successful super fund is diversification. Be careful not to underestimate the costs involved in managing a SMSF and always seek professional advice before buying.
- Make sure you have the appropriate insurances in place in the event of an economic downturn. For example, landlord insurance for rental property owners and *income protection in the event of job loss. Having financial protection in place can prevent you being forced to sell at a loss.
Although infrequent, housing bubbles can happen and it’s important you don’t ignore the signs. It’s easy to get caught up in the hype with interest rates at record lows and house prices continuing to surge, but make no mistake – things can change very quickly.
Don’t rely on mortgage lenders and real estate agents for advice. Be responsible for your own budget and making calculated decisions that don’t jeopardise your financial security.
Most importantly, be careful how deeply you go into debt.
*As highlighted to us by one of our followers, income protection does not protect you in the event of job loss. Some companies, however, do offer involuntary unemployment cover which can provide temporary relief if your job is suddenly made redundant. Another option is mortgage protection insurance which covers your mortgage repayments in the event of job loss for a certain amount of time.
What’s your opinion, are we heading into a housing bubble?