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What is a Housing Bubble and What Causes One?

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A housing bubble is when home prices rise rapidly and become unsustainable due to a surge in demand and real estate speculation. Low mortgage interest rates and relaxed credit standards lead to more people being able to afford a home, which, in turn, can increase demand.

As a result, home prices rise until they become unaffordable and demand eventually falls. That’s when the bubble corrects itself and home prices slip by 10% to 20% or more, depending on the market. This can lead to more favorable prices for buyers.

What is a housing bubble?

Typically, unsustainable factors fuel a rise in housing prices until an impending decline, said Lawrence Yun, chief economist with the National Association of Realtors.

In general, the housing market is stable when there’s a balance between the number of buyers who can qualify for a home and the number of affordable homes on the market. If there’s a surge of borrowers who can qualify for a mortgage who couldn’t in the past, that increases housing demand, which drives up housing prices and can create a housing market bubble. Additionally, speculation, or buying a property with the assumption that you can sell it at a higher price later, is a driving force behind housing bubbles, said Tendayi Kapfidze, LendingTree’s chief economist.

What causes a housing bubble and why does it burst?

Lending money to homebuyers and overestimating their ability to repay can also cause a housing bubble. But, in many cases, a bubble arises because of real estate speculation.

“Where we thought that there was a change in fundamentals, we come to realize that with all previous bubbles, no, there was just speculative investing and unrealistic assumptions,” said David Reiss, a law professor and research director of the Center for Urban Business Entrepreneurship at Brooklyn Law School in New York City. “And when enough people realize that, prices correct and they crash. That’s exactly what we saw during our most recent housing bubble in the early 2000s.”

As housing prices and demand increase, more homes are built. After a bubble bursts, though, new homes can languish on the market, because it takes time for builders to buy land, get permits and secure financing. By the time new houses are completed, there may already be a housing bubble recession in the works. 

2005-2006 housing bubble explained

The primary factor in what caused the housing bubble was lenders offering home loans without accurately assessing borrowers’ ability to repay. “Somehow, Wall Street believed that [lenders] can just give out easy loans to anyone and rising prices will justify the collateral value [of the homes],” Yun said. Trillions of dollars poured into the market that weren’t there before.

This also drove down mortgage interest rates, which led to a surge in mortgage originations. This cycle increased demand for homes, which drove up prices. Builders responded to the demand by building a “huge amount of excessive homes above historical normal,” Yun said.

How the housing bubble gave way to the housing crisis of 2007-2008

The bubble burst when unsustainable factors became, well, unsustainable. As home prices rose, homebuyers were having a harder time finding affordable homes to purchase. First-time homebuyers were being priced out of the market, as many home loan programs popular with first-timers, such as Federal Housing Administration (FHA) loans, have limits. Mortgage rates started to increase. Home prices started to drop, and investors pulled out of the real estate market.

Many homebuyers are owner-occupants. They purchase their home with the intent of living there. This gives homebuyers an incentive to work with their lender, even when their home values dropped. Moving is difficult, and as housing prices dropped, it became harder for homeowners to sell their homes and recover their losses.

Investors didn’t have the same incentive to keep their homes. They were able to buy homes with little or no money down during the bubble, allowing them to walk away when home prices dropped with no consequences. Even owner-occupants were forced to go into foreclosure. The financial fallout led to financial institutions, including Lehman Brothers, filing for bankruptcy — the largest in history.

Are we in a housing bubble?

Experts don’t believe so. Why? For starters, the same factors that led to the housing crisis in 2007 to 2008 are not in play; lending conditions are a bit tighter than normal, Yun said. The market also doesn’t have a surplus of homes as it did in previous bubbles, he added.

“In fact, we have a significant underproduction that is leading to a housing shortage,” Yun said.

Kapfidze predicted slow-but-steady growth in the mortgage market for 2020 in a recent LendingTree housing outlook. He forecasted moderate home-price growth at about 3% year over year.

Reiss cautions against looking only at U.S. housing market conditions from a national perspective.

“Housing markets are local,” Reiss said, adding that you can’t generalize from one part of the country to the other.

Reiss added that looking at national averages doesn’t always give an accurate picture either. If one state has prices that went up 10% and another state has prices that went down 5%, the average would tell one story. But each state and city experiences a different housing market, and it’s unusual for there to be a national bubble; they tend to be local.

When will the next housing bubble be?

There’s no definitive answer to when the next housing bubble will be. The real estate market is cyclical, but it’s also more difficult to obtain a mortgage now than it was during the housing bubble. Rather than looking for an answer at the national level, it’s best to focus on what’s going on in your local market. Some markets are still experiencing the effects of the last housing bubble and burst.

Another reason it’s difficult to predict housing bubbles is that they are rare, and certainly not on the same scale as the one from 2005 to 2006. “Aside from local economic displacement factors, America really never had that housing price bubble and crash other than that subprime lending period,” Yun said.

On a national level, we’ll continue to see low interest rates and credit requirements loosen slightly as the recovery from the last housing crisis continues.


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