How to weather a market downturn

In recent years, real estate has seemed like a can't-lose investment. In many parts of the U.S., housing prices have gone up more than 70 percent in the past five years, and in a few red-hot markets 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 percent. If the market in your area has since climbed 15 percent, your home is now worth $287,500. You’d have paid only about $9,000 in principal while building over $96,000 in equity.

But it's important to be prepared for a possible real estate decline. Should the housing bubble burst, 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 can't control the real estate market, but you can do the following things to protect yourself from a potential market downturn:

Buy within your means
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 makes you particularly vulnerable if the market turns, since your equity is low to begin with.

Keep your loan-to-value ratio below 80 percent
Your mortgage principal, plus any home equity loans you may have, should total no more than 80 percent of your home's current value. Not only will this get you a better loan rate and remove the need to pay private mortgage insurance (PMI), but it also builds in a healthy cushion if the value of your home drops.

Don't buy and flip
Homebuyers may get into trouble if they plan to sell within a year or two, since they're not building in time for the market to recover if it drops. You have less to worry about if you plan to stay in your home for at least five years.

Don't stretch your home equity
A home equity loan (HEL) can be an affordable way to consolidate debt, finance a renovation or cover other large expenses. However, stretching your home equity too thin is risky if the market is headed for a downturn. If you expect the market to cool off, then it's not the time to take out a HEL to pay for a luxury, such as a vacation or fancy car.

Be wary of cash-out refinancing
Some homeowners dip into their home equity when they refinance, taking out a new mortgage with a higher principal and putting the extra funds toward a major purchase. However, just like taking out a home equity loan, this is riskier if a market downtown is on the horizon.

Pay down as much principal as you can
The less equity you have in your home, the harder you will be hit if the real estate market drops. That's why interest-only mortgages and option ARMs bring higher risk: they do little or nothing to reduce the loan's principle. 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 market shouldn't cause too much concern.