Don't Bet the House

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The best definition of a housing bubble is this: we are in one when most homeowners could not afford their house at its current market value. Rapidly rising prices coupled with stagnant wages in recent years have created just such a disconnect for many people. If you're one, now is the time to look at how you are using, and what you are doing to protect, your valuable home equity.

The debate rages as to whether housing prices have got out of whack with reality — like Internet stocks four years ago — and are likely to collapse in the next year or two. I'm not convinced. An increase in the rates of immigration and household formation are fueling demand, and the lowest interest rates in 45 years are keeping houses affordable. Even as home prices rose nearly twice as fast as disposable income last year — and mortgage debt surged 13%--total monthly consumer-debt service remained remarkably stable.

Still, there's no denying that a sharp rise in rates would pose problems for the housing market, as would continued job cutting in an economy that is failing to pick up steam or, possibly, a deeper scandal at embattled mortgage firm Freddie Mac. Here are three ways to prepare for a bust:

SELL This is an extreme measure and a bad idea if you plan to stay in your house at least five years. But if you know you'll be moving soon, do it now — or consider selling and then renting nearby for a year or two to lock in what may be peak prices. Don't be in a hurry to jump into another house. Apartment vacancies are running at 9.4% of capacity, the highest in nearly 50 years, reports the Economic Policy Institute. Rents should start coming down.

HEDGE Keep the house, but dump any other real estate assets. Stocks of home builders, mortgage lenders, movers, furniture companies and real estate investment trusts will sink if the housing market goes bust. In his book The Coming Crash in the Housing Market, author John Talbott suggests selling these stocks short or buying "put" options on them. Both strategies produce gains as stocks fall. These sophisticated moves should not be made without consulting an adviser.

MANAGE YOUR DEBT Make extra payments to get your mortgage balance below 75% of your home's appraised value. That way, if prices fall 25% and you find you must sell (job loss, divorce), there would be no out-of-pocket cost. If buying or refinancing now, consider only fixed-rate loans to lock in low rates — and keep in mind the new "portable" mortgage from eTrade, which lets you lock in a low rate and transfer it from house to house for 30 years.