What Is a Housing Bubble?

What Is a Housing Bubble?

A housing or real estate bubble is a run-up in housing prices fueled by demand, speculation, and exuberant spending. Housing bubbles usually start with increased demand in the face of limited supply. Speculators further drive up demand by investing money into the market. When demand decreases or stagnates as supply increases, prices drop, and the bubble bursts.

What Causes a Housing Bubble?

A housing bubble may be driven by something outside the norm, such as manipulated demand, speculation, unusually high levels of investment, excess liquidity, a deregulated real estate financing market, or extreme forms of mortgage-based derivative products.

These factors can cause home prices to become unsustainable, leading to an increase in demand versus supply. Housing markets aren't as prone to bubbles as other financial markets due to the large transaction and carrying costs associated with owning a house.

However, a rapid increase in the supply of credit leading to a combination of low-interest rates and a loosening of underwriting standards can bring borrowers into the market. A rise in interest rates and a tightening of credit standards can lessen demand, causing the housing bubble to burst.

Effects of a Housing Bubble

Housing bubbles affect communities and the overall economy. They can force homeowners to look for ways to pay off mortgages through various programs or they may have them digging into retirement accounts to afford to continue living in their homes. A housing bubble can significantly cut into the equity in a home and homeowners often find that their mortgage balance is more than the value.

Homeowners may force foreclosure once the value of the home plummets and the mortgage exceeds the equity. Foreclosure occurs when a lender attempts to recover the amount owed on a defaulted loan by taking ownership of the mortgaged property and selling it. Typically, default is triggered when a borrower misses monthly payments or fails to meet other terms in the mortgage document.

Housing Bubble Example

A U.S. housing bubble occurred following the financial crisis of 2007-2008. Following the dot-com bubble bursting in the 1990s, investors moved their money from start-up technology company stocks into real estate. The U.S. Federal Reserve cut interest rates to combat the mild recession that followed the technology bust and to assuage uncertainty following the World Trade Center attack of Sept. 11, 2001.

Government policies encouraged homeownership and financial market innovations increased the liquidity of real estate-related assets. Home prices rose as interest rates plummeted. It's estimated that 20% of mortgages in 2005 and 2006 went to buyers, known as subprime borrowers, who would not have been able to qualify under normal lending requirements. Over 75% of these subprime loans were adjustable-rate mortgages with low initial rates and scheduled resets after two to three years. 

The government’s encouragement of broad homeownership induced banks to lower their rates and lending requirements. This spurred a home-buying frenzy that drove the median sales price of homes up by 55% from 2000 to 2007. Adjustable rate mortgages began resetting at higher rates in 2007 as signs that the economy was slowing. Housing prices declined 19% from 2007 to 2009, triggering a massive sell-off in mortgage-backed securities.

The Bottom Line

A housing bubble can significantly affect a home's value and the equity in real estate. As prices climb, investors may flood the market, and home buyers may secure risky loans. When the bubble bursts, prices plummet and some borrowers may face financial stress or foreclosure.