There’s been plenty of talk in the media (and even more around Australia’s barbecues) about the sharp growth in house prices. Houses in suburban Sydney are selling for seven figures at a rate never before seen and other capitals (especially Melbourne) are amazingly expensive, too – which is to say nothing of the shoebox-sized inner-city places that are selling for more than a couple of lotto jackpots.

Investors are rushing into the market at a rate of knots, with a sizeable increase in both the number of investors and the proportion of interest-only loans being made by our banks. And with house prices increasing (much) faster than incomes, a little second grade maths will tell you that more and more of our household income is now going towards the roof over our heads.

Don’t thank god, thank Glenn

Reserve Bank governor Glenn Stevens is doing his bit to keep affordability reasonably low – but it’s unlikely the official cash rate will have a 2 per cent in front of it for any significant length of time. Most mortgage holders today won’t have been paying off their homes when interest rates hit 17 per cent in the early 1990s, but just ask someone who was… you’ll get a proper definition of mortgage stress!

We won’t see 17 per cent again any time soon – if ever – but such is the leverage of Australia’s households and property investors, there’d potentially be significant economic consequences if rates hit 7 per cent or 8 per cent – let alone 10 per cent or 12 per cent.

In short, we have a situation characterised by household leverage of a size never before seen, house prices that are growing faster than wages and investors who are banking on prices continuing to rise, and never mind that rental yields don’t even go close to covering the interest in many parts of Australia.

So is it a bubble? No one really knows. And it’s fair to say that there are far more bubbles forecast than ever eventuate. The problem with bubbles is that they’re only really clear in hindsight – which is no good to anyone.

What seems clear is that the combination of leverage and – to put it bluntly – speculation leaves us precariously placed. It may not require much in the way of a shock (internal or external) to do us damage.

Be prepared

If you can’t predict a bubble in advance, what can you do? Simply, what our parents and their parents would have told us to do (there’s a reason that timeless advice is timeless!).

If you’re buying, don’t overstretch. If you have a 5 per cent deposit and house prices do fall 10 per cent or 20 per cent (or more), you’ll be underwater by a long way.

If you have a mortgage, pay it off, fast. Not in a reckless way, but as super investor Warren Buffett has said, you don’t want to be relying on the kindness of strangers (i.e. your bank manager) if rates go up or if prices fall.

If you’re a renter, you’re probably the most protected from any shocks – and you might even have the whip hand in any subsequent lease negotiations if the landlord is under financial pressure.

If you’re a property investor, reduce your leverage. Then do it again. If you think home owners are reliant on the kindness of strangers, property investors are one pen stroke away from being forced to refinance – and if no one else will come to the party, potentially selling at a (big) loss. And if your loan is interest only, that’s debt that could bring your finances crashing down.

Foolish takeaway

If there’s no bubble, or that bubble doesn’t burst, the advice above will let you sleep at night and means you’re never at someone else’s mercy. But if you ignore that advice and the bubble bursts, you’ll have no redress at all.

To return to Buffett, who was speaking about leverage and risk: “To make money they didn’t have and didn’t need, they risked what they did have and did need… if you risk something that is important to you for something that is not important to you, it just doesn’t make any sense.”

Maybe there’s no bubble. But how much are you risking, if you’re wrong?

Posted by Scott Phillips – Money Manager (Fairfax Digital) on 3rd February, 2015