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New mortgages entice borrowers by keeping initial payments low

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The pitches of mortgage lenders have started to sound more like those of car-loan companies: It's all about keeping the monthly payments down.

As interest rates inch higher and home prices continue to soar in many parts of the country, loans that promise affordable payments and enticing introductory rates can be a practical way to stretch your dollars to secure a home that otherwise might be out of reach. For some people, they're also a way to keep more cash on hand for other investments.

But these mortgages come with a cost that isn't always immediately apparent. With many of these products, home buyers won't make a dent in their principal balance for several years. And buyers who take out large mortgages could wind up in a deep financial hole if real-estate prices fall.

For many people, the danger in this overheated market may be taking out a mortgage that in the long run they can't really afford.

"In some circumstances, they can buy more house than they might otherwise qualify to buy" with some of these products, says Jack Guttentag, professor of finance emeritus at the University of Pennsylvania's Wharton School in Philadelphia. "That doesn't necessarily make it a wise decision for the borrower, but it is a decision a lot of them are making, especially in areas where prices are appreciating very rapidly."

These new mortgages come in all shapes and sizes. The product most in demand, especially in areas where home prices exceed national averages, allows borrowers to make interest-only payments for several years -- though of course that means you aren't chipping away at the principal.

Another hot product, which can be used in combination with the interest-only option, is the hybrid adjustable-rate mortgage, which allows borrowers to enjoy a fixed rate for several years, before shifting to an adjustable rate.

Still another provides several payment options each month, including a bare-minimum payment that could cause the loan balance to swell.

"A year ago, it was a no-brainer for someone who thought they'd be in a home less than 10 years to consider an ARM over a fixed-rate loan because the difference in rate was very wide, as much as two percentage points at some point," says Bob Walters, chief economist at Quicken Loans of Livonia, Mich. "The advantage is still there, but it's not as pronounced, so we are seeing more people taking longer-term (hybrid ARMs) and more 30-year fixed."

More popular still is a mutation of the hybrid ARM: adding an interest-only option, where borrowers pay interest and no principal in the loan's early years, which typically coincide with the fixed period of the ARM. This keeps monthly payments much lower than if you were also paying down principal. In fact, about 33 percent of all new home loans are interest-only, according to LoanPerformance, a mortgage-data company in San Francisco that tracks 46 million mortgages monthly.

In some areas, it's much higher than that: In San Diego, interest-only loans make up more than 67 percent of new mortgages.

These loans are almost -- but not quite -- like renting your house with the option to buy. You have a locked-in purchase price, and you also receive a nice tax deduction on the interest. You can pay down principal if you want to during those interest-only years -- typically up to 20 percent annually -- without penalty.

If you don't, or if you don't refinance with a traditional mortgage, you will face a much higher payment when the fixed period expires. That's because the loan must then be amortized over a condensed period, say 20 or 25 years, as opposed to 30. Pair that with a potentially higher interest rate, and payments can skyrocket.

Case in point: a $300,000, 30-year fixed-rate mortgage with an interest rate of 5.5 percent would cost $1,703.37 monthly. Compare that with a 5/1 interest-only ARM with a 4.5 percent rate (5/1 means the initial rate is fixed for five years, then adjusted annually). This loan costs $1,125 a month, and saves borrowers $578.37 each month for those first five years. (Another caveat: The interest rate on interest-only loans typically runs about an eighth or a quarter of a percentage point more than on comparable interest-and-principal loans. So the rate on a 5/1 interest-only ARM would be slightly higher than on a regular 5/1 ARM.)

But the interest-only ARM can deliver a double whammy. When the five-year interest-only period expires, if the rate rises two points (the biggest change some ARMs can make per adjustment), to 6.5 percent, the monthly payments will soar more than $900 to $2,025.62 -- reflecting both the higher rate and the start of principal payments. That's not a winning proposition for someone who wanted a low monthly payment.

Lenders say most people are tailoring the loans to their life plans and typically expect to move after the fixed-rate period is up, with hopes that their home has appreciated in value, or to refinance. But both options still involve risks: Borrowers may need to stay in their house longer than anticipated and rates could march higher. Or, if housing prices decline, even slightly, you may be left with a mortgage larger than your home's value.

Meanwhile, a traditional 5/1 ARM on the same $300,000 mortgage with a 4.5 percent interest rate would cost $1,520.06 monthly -- considerably more than with the interest-only version. But after the five-year fixed period, more than $26,500 in principal would have been paid off. Then if rates have risen to 6.5 percent, payments would increase to $1,846.51 -- nearly $200 a month less than the interest-only version.

"An interest-only loan is like a steak knife. If you grab it by the right end, it's a good tool," says Greg McBride, an analyst at Bankrate.com, a consumer-finance Web site based in North Palm Beach, Fla. "It enables borrowers to devote more money to maximizing their investments, their 401(k), their IRA, additional real estate or other investments that they'd rather devote money to rather than paying back principal."

Three years ago, David Lutz and his wife built their 6,000-square-foot dream home in Cohasset, Minn. However, saddled with $50,000 in credit-card debt due in part to home-appliance purchases, they recently decided to refinance. They wrapped the card debt, along with a $15,000 loan for Mr. Lutz's business of designing and selling orthopedic equipment, into a 30-year fixed mortgage with a 10-year interest-only period. (Their interest rate declined about a third of a percentage point.) Though their mortgage grew to $382,000 from about $316,000, their payments are $1,127 a month lower, and they can funnel the difference into Mr. Lutz's business when need be. They are also applying between $300 and $600 a month to principal, which Mr. Lutz says will total somewhere between $40,000 and $50,000 after 10 years.

"We were able to handle every payment, but I'm growing my business," Mr. Lutz says. Moreover, since the nature of his business sometimes causes a 45-day stretch between paychecks, the new loan gives him more flexibility to pay what he can when he can. He also rid himself of credit-card interest, which isn't tax-deductible.

"People are really payment-focused; they're less concerned about the forced-savings aspect of fully amortizing loans," says Frank Sillman, executive vice president of mortgage banking at IndyMac Bank, a unit of Los Angeles-based IndyMac Bancorp Inc.

Another new product some lenders are pushing, known largely as option adjustable-rate mortgages, also provides payment flexibility for people with varying incomes.

The option ARM gives borrowers as many as four payment options each month, which typically include a minimum payment, an interest-only payment, a traditional payment based on a 30-year term or an accelerated payment on a 15-year term.

"The big disadvantage is that a buyer could opt for a smaller monthly payment at the cost of building equity or a large payment shock later if unpaid interest is added to the balance," says Bankrate.com's Mr. McBride.

For instance, borrowers who make minimum payments might find they aren't covering all of the interest due in a given month. Any shortfall is added to the loan balance. Known as "negative amortization," this leaves the customer owing a larger principal amount.

Option ARMs aren't the best choice if short-term rates continue to rise because their rates could approach fixed-rate levels or even higher. "The option ARMs have a relatively low starting payment, but the actual interest rate in the second month jumps quite a bit from the start rate," says Joe Rogers, executive vice president at Wells Fargo Mortgage, a Des Moines, Iowa, unit of Wells Fargo & Co. (NYSE: WFC).

"These loans will definitely rise over the next few months based on the index they are tied to."

Here's how they work: Rates adjust monthly after the introductory period expires, which can be as short as a month. A new minimum payment is calculated each year. Minimum payments typically can't rise more than 7.5 percent annually, though they can rise more than that every five years to be sure the borrower is on schedule to pay off the loan by the original term, usually 30 years. And the minimum option can be eliminated if the loan balance hits a certain threshold, usually 110 percent to 125 percent of the original loan amount, lenders say.

Confusing, yes. That's why borrowers now more than ever need to focus on educating themselves.

"The products that feature more risks aren't bad products per se, but they should be a niche market for people who understand the risks and have the financial wherewithal to manage the risk if conditions don't turn out exactly as they hope," says Keith Gumbinger of HSH Associates, financial publishers in Pompton Plains, N.J. "Unfortunately, this business does suffer from a bit of financial hucksterism. ... It's safe to say that some of the mortgages today are the foreclosures of tomorrow."

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