The Rating Game

Many Hawaii homeowners
have gambled their homes
that interest rates won't soon
rise too high for comfort

American homeowners have made a trillion-dollar bet that mortgage rates will remain near record lows for at least a few more years. But with some interest rates already rising, economists worry that the bet could turn bad.

The problem is that new types of mortgages that hold down monthly payments for families -- helping many buy homes that they would not otherwise be able to afford -- also require potentially far higher payments in future years.

The bill will soon start to come due in a serious way when the initial period of fixed payments, typically set at artificially low rates, expires for millions of homeowners with adjustable-rate mortgages.

This year, only $83 billion, or 1 percent, of mortgage debt will switch to an adjustable rate based largely on prevailing interest rates, according to an analysis by Deutsche Bank in New York.

Next year, some $300 billion of mortgage debt will be similarly adjusted.

But in 2007, a time bomb could go off when $1 trillion of the nation's mortgage debt -- or about 12 percent of it -- will switch to adjustable payments, according to the analysis.

The 2007 adjustments will almost certainly be the largest such turnover that has ever occurred.

For individual families, the problems could be significant.

Consider a typical $300,000 interest-only mortgage with fixed payments for the first three years, taken out last summer.

The homeowner would now be paying about $1,200 a month. If interest rates rose modestly over the next two years, as many forecasters expect, the payment would jump to more than $2,000 in 2007, according to Stephen Barrett, the owner of Redmond Financial, a mortgage business near Seattle.

"I'm not sure that people are being counseled on really how big of a risk they are taking," said Amy Crews Cutts, deputy chief economist at Freddie Mac, the mortgage company.

With the help of new computer models, lenders have brought out newer and riskier mortgages to attract borrowers and boost their buying power during the long housing boom.

The traditional 30-year mortgage with guaranteed payments is increasingly a loan of the past.

The hot loan of 2004--the interest-only mortgage--allowed homebuyers to pay no principal for the first few years of the loan, substantially lowering their initial payments.

It has remained popular this year, accounting for at least 40 percent of purchase loans over $360,000 in areas with fast-rising home prices, like San Diego; Washington, D.C.; Seattle; Reno, Nev.; Atlanta; and much of Northern California, according to LoanPerformance, a mortgage data firm.

In Hawaii, interest-only loans were used for one in four home purchases so far in 2005, LoanPerformance reports. That ranks the Aloha State No. 10 based on the prevalence of those loans.

Adjustable-rate mortgages are gaining increasing popularity, too, said Richelle Thomason, vice president and national marketing director of Stanton Mortgage in Honolulu.

In fact, she said, her firm has begun to offer a product with a twist on the traditional ARM.

Known as a pay-option ARM, the loan lets borrowers choose to make a minimum payment, an interest-only payment or an amortized payment of interest and principal.

Thomason acknowledged that such a mortgage was not for everyone -- home buyers, she stressed, need to educate themselves extensively before taking out any kind of mortgage -- but she said for some people, the pay-option ARM is perfect.

For example, Thomason said, she recently did a pay-option ARM for an Air Force officer who plans to leave Hawaii in four or five years, before she could be slammed with a higher interest rate. In the meantime, the officer gets to invest her housing allowance in Hawaii real estate, which, if the last few years is any indication, appears likely at least to hold its value.

Likewise, Thomason said, the loan would be good for an investor who planned to keep the property for a short time then flip it in the hope of making money.

Finally, she said, the pay-option ARM is good for the same types who are flocking to traditional ARMs: people who work for themselves.

"I think the most important thing is that it's good for people who are self-employed, whose income fluctuates," she said.

Still, Thomason reiterated, people need to know what they're getting into.

"Bottom line is they gotta know they're on an adjustable," she said.

A new model in use nationwide, known as an "option ARM," allows borrowers to make payments with monthly rates as low as 1.25 percent for the first five years of the loan; the average rate on a 30-year, fixed-rate loan is about 5.6 percent.

During the first quarter of 2005, 40 percent of mortgages over $360,000 issued to people with good credit were option ARMs, said David Liu, a mortgage strategy analyst with UBS in New York. Option ARMs barely existed in 2003.

Many borrowers stand to benefit from these creative loans. With the average homeowner moving every six years, loans with initially lower payments can substantially reduce housing costs. Buyers with variable incomes, like the self-employed, also can make smaller or larger payments depending on their take-home pay in a particular month, without incurring penalties.

But all of these loans come with the risk of a spike in payments at some point in the future.

In particular, borrowers who have taken out an interest-only loan will see a jump in payments simply because they will then start to owe principal after the interest-only period lapses. If rates rise, the payments will go even higher.

Borrowers whose incomes have not risen sufficiently or who have not planned for the increase in payment could find themselves shocked.

Still, even some mortgage brokers are concerned by how much their clients are stretching their spending power using creative mortgages.

One possible warning sign is that a growing share of people taking out the aggressive loans are lower-income families who live in expensive areas, according to Economy.com, a research company.

Another is that variable-rate mortgages have stayed popular even as rates on fixed-rate loans have gone down.

"There are people who are buying homes that they shouldn't buy," said Eric Appelbaum, president of Apple Mortgage Corp. in Manhattan.

"People are saying I can afford it on interest-only but I can't afford it" with a traditional mortgage, said Appelbaum. "It doesn't make any sense."

Since borrowers with interest-only mortgages are not yet paying down their debt, they are hoping to build up equity through an increase in home values. If house prices fall, as they did during the early '90s in some cities, borrowers will be forced to bring money to the table when they sell.

Even if home prices go up a little, borrowers who have taken out option ARMs and made only minimum payments for five years could find themselves in a hole. Such loans, which are typically based on rates that adjust monthly, give home owners four payment options each month.

In the first quarter of 2005, 70 percent of option ARM borrowers paid the minimum payment, according to UBS.

In doing so, those borrowers effectively added more debt to the back of their loans.

On a $400,000 loan, for example, a buyer who made only minimum payments over the first five years would add more than $27,000 to the back end of the loan, assuming short-term rates increase by 1 percentage point over the course of the loan, said Robert Binette, a mortgage broker with Hamilton Mortgage in Ridgefield, Conn.

The monthly payment would jump from $1,718 in the final month of the fifth year to $2,580 after the loan reset, a difference of more than 50 percent.

Borrowers who expect to cover the larger debt by refinancing could be in trouble if rates have increased. Thirty-year fixed mortgage rates are near their lowest level in a generation.