Mortgage trend poses risks in downturn

To afford Greater Boston's soaring home prices, one in four homebuyers last year took out a risky, interest-only mortgage that offers lower monthly payments in the initial years of the loan but raises payments sharply in later years.

In 2002, just 5 percent of new mortgages in the Boston area were interest-only, according to LoanPerformance, a San Francisco firm that tracks the housing market.

Housing specialists say the growing dependence on these loans could spell trouble for the housing market if interest rates rise and house prices stagnate or fall, and large numbers of homeowners are unable to pay their mortgage bills. If they can't and decide to sell, a glut in the market would send prices spiraling downward.

''If the only way that new buyers or people trading up can afford to do so is by taking out interest-only loans, they've hit the ceiling in terms of affordability," said David Stiff, an economist for Fiserv CSW Inc. in Boston, a real estate research firm. Tough times, he said, ''will dry up [housing] demand very quickly, because people are already tapped out."

Interest-only mortgages are a type of adjustable-rate mortgage with an introductory interest rate that is somewhat lower than rates on traditional, fixed-rate mortgages. The rate eventually adjusts to prevailing market interest rates. The difference, however, is that the borrower can pay only the interest -- and no principal -- in the early years of an interest-only loan, typically the first five to seven years.

The initial savings can be substantial. Payments on a $350,000 mortgage -- the median home price in Greater Boston -- would be $1,789 a month with a typical 30-year, fixed-rate mortgage. That same house would cost a homeowner with an interest-only mortgage just $1,345 a month in the first five years -- a difference of $444 a month. After five years, when the borrower begins to pay the principal, the monthly payment increases.

Economists have been warning of the dangers of rising real-estate prices for several months. Federal Reserve Board chairman Alan Greenspan worried recently that real estate markets in some regions are showing signs of ''froth," though he did not identify which markets. His comments echoed the warnings he made about ''irrational exuberance" in the stock market before the Internet bubble burst in March 2001.

Homebuyers, Greenspan said, ''are reaching to be able to pay the prices to be able to move into a home."

The monthly payment on Don Frattaroli's interest-only loan from Summit Mortgage LLC will be $1,740 for the first five years, if he pays only interest. Then the payment will rise to about $2,490. An interest-only loan ''does allow me to buy more house," said Frattaroli, 36, who is trading up to a $497,000 South End condo that is larger than his former condo and has a roof deck and parking.

Frattaroli, who works for Hewlett-Packard Co. and cohosts a cable-television talk show on the Boston Neighborhood Network for the homosexual community, SpeakOut TV, makes a high income. His issue is cash flow: One-third of his compensation comes twice a year, as performance bonuses. The rest of the year, his budget is tight.

''I'm willing to take the risk, because I believe, at worst, prices will level off and not decline," he said of his interest-only loan.

Even though 30-year, fixed-rate mortgages are near historic lows, more Boston-area homebuyers also are choosing standard adjustable-rate home loans, betting that rates will not go up. Last year, almost half of borrowers had an adjustable-rate loan, the highest level since 1988, when mortgage rates were above 10 percent.

Shannon Cook and Joe Ewer figure they won't live in their first condo very long. The couple took out an adjustable-rate mortgage when they bought a place in South Boston in August and borrowed the entire $350,000 purchase price. They're comfortable with a $2,250 monthly payment, which includes taxes and insurance.

The rate is fixed for three years, after which it will adjust annually to market rates, Cook said. But she is confident their property will appreciate, and they can either sell or refinance at a better rate. ''It has to" appreciate, she said, because ''they're not making any more land."

Investor speculation is rampant in real estate markets such as Arizona and Florida. But in mature markets such as Boston and San Francisco, where house prices were already high, homebuyers are turning to low-rate loans simply to afford a place to live.

Massachusetts home values rose 50 percent, more than any other state, between 2000 and 2003, according to a US Census Bureau survey of homeowners released last week. Second was California, up 46 percent. Use of interest-only loans in San Francisco and the Bay Area there is among the highest in the country, exceeding 50 percent of all mortgages.

Summit's senior loan officer, Rosella Campion, said interest-only loans are prudent for some homebuyers. People today are more mobile than prior generations, who lived in one house for decades and paid it off, she said. These loans drain less of their disposable income. When the owners move, they can pay off the loan -- if home prices continue to rise.

''It is just a new way of perceiving homeownership and how it's going to benefit you," Campion said. She also pointed out that interest-only loans also give homebuyers the option of paying down the principal in the early years.

LoanPerformance, a unit of First American Corp., said about 85 percent of interest-only loans are refinanced within four years. ''That could change if interest rates go up," said Bob Visini, vice president.

If homebuyers' payments start to rise faster than their incomes, ''a lot of working people will be in a very tough spot," said Greg McBride, senior financial analyst for Bankrate.com, a personal finance website.

Kimberly Blanton can be reached at blanton@globe.com.