Beware the time bomb ticking in some low-cost mortgages

ONE OF THE MOST popular home mortgages this year could also prove to be one of the most toxic to the unwary: low-down-payment, short-term "interest-only" adjustable-rate loans.

Designed to allow consumers to stretch their incomes and qualify to purchase homes at below-market starting rates in the 4 percent to 5 percent range, these mortgages come with built-in time bombs: After the initial three- or five-year fixed-payment, interest-only period elapses, they morph into standard-payment adjustable mortgages with full contributions to principal.


The biggest time bomb is the first monthly payment after the interest-only period, which may be from 30 percent to 70 percent higher than the homeowners had paid earlier.

Mortgage brokers say that many buyers are oblivious to the payment shocks lurking on the near horizon, or simply have no plan on how to handle such large increases in monthly expenses. Other buyers are apparently betting on high rates of real estate appreciation to bail them out - never a wise strategy at the tail end of a decade-old price boom.


Interest-only mortgages traditionally came with extended periods - 10 years or more - where no principal reduction was required as part of the monthly payment. But recently, lenders have begun pushing short-term interest-only plans to qualify greater numbers of homebuyers in a rising-rate environment.

In an interest-only plan, the lender sets a come-hither initial fixed-payment rate - say 4.5 percent - to pull in customers. During this initial period, monthly payments are artificially low because none of the payment goes toward lowering the principal balance of the mortgage. Most interest-only three- and five-year plans convert from fixed-payment to an adjustable rate - reset annually or monthly - for the remaining term of the loan, usually 25 to 27 years.

Once the initial period is completed, contributions toward principal reduction begin. That feature alone virtually guarantees higher monthly payments. Also, in an environment of rising interest rates, the index governing the loan payments can rise unpredictably, sometimes raising the mortgage rate by as much as 5 percentage points, the "cap" typically included in the plan.

But even a modest 1 percentage point increase in market rates at the end of the interest-only period can produce hefty increases in monthly principal and interest payments.

Consider this illustration: Say you need a $333,700 mortgage to buy a townhouse. Your lender offers a five-year interest-only loan at 5.25 percent that converts to a one-year adjustable after 60 months. Even if rates stay flat during the 60-month interest-only period - not likely in the current economic scenario - you'll still get hit with a 30 percent payment spike when principal reduction kicks in. If market rates increase by just 1.5 percentage points, your monthly payment will rise 50 percent. A 2.5 percentage point gain would push up your payment by 64 percent.

Would you be able to afford a mortgage payment that is 64 percent higher 60 months from now? Consumer-oriented mortgage brokers and lenders say they worry that many homebuyers who are now taking out short-term interest-only loans will not. Nor will they necessarily have easy refinancing or resale options, especially if home real-estate appreciation rates go soft, flatten out or go negative.

"Some of these people think real estate values can only go up and interest rates only stay low," said Philip X. Tirone, executive loan officer with First Capital Mortgage in Santa Monica, Calif. "They have no memories, no idea" about how quickly super-heated housing markets can cool, such as Southern California's 20 percent to 30 percent losses in the early 1990s after the sizzling 1980s.

Though Tirone says he frequently talks clients out of short-term, interest-only programs, some tell him that they have no other way to "get in on this real estate boom and make a lot of money quickly."


Without substantial increases in household income, Tirone said, "a lot of these [interest-only] borrowers could be looking at potentially big trouble" in three to five years.

Some major institutional players in the home mortgage market agree. The top credit official for mortgage insurance giant MGIC Investment Corp., David Greco, believes that while short-term, interest-only adjustables "can be very useful tools" for well-informed consumers, "they can pose a substantial risk to an unknowing, unprepared borrower."

The risks of payment-shock blowups and foreclosures on today's interest-only deals multiply when borrowers take advantage of lenders' zero down payment, low credit score and high debt-to-income add-on features.

The takeaway here: Never focus solely on the upfront qualifying rate that gets you into the home. Ask yourself how and where you're going to come up with a 50 percent to 60 percent higher monthly payment three years from now.

If you don't have an answer, maybe interest-only isn't the game for you.

Ken Harney's e-mail address is