Posted on: Saturday, April 9, 2005

'Interest-only' loans may be boon — or bust — for Calif. homebuyers

By David Streitfeld
Los Angeles Times

OAKLAND, Calif. — Rachael Herron's new condo will assure her financial salvation — unless it provokes her ruin.

Herron put no money down for her tidy one-bedroom, borrowing the entire purchase price of $211,000. To keep her monthly payments as low as possible, she got an adjustable-rate mortgage that won't require her to pay any principal for three years.

Thanks to her "interest-only" loan, the 911 police dispatcher was able to afford, barely, her first home. She now has a stake in California's sizzling real estate market. As her home increases in value, she plans to use some of that equity to pay down her credit cards.

But Herron is also setting herself up for a day of reckoning: Nov. 1, 2007.

That's when she has to start paying off her loan principal. If interest rates are higher than when she bought her home last fall — something many economists consider probable if not inevitable — her monthly payment will increase by as much as a third.

"I don't know what I'll do," said Herron, 32. "I'm already working overtime to pay my bills."

Buy now, pay later

Confronted with soaring home prices, Californians are adopting a "buy now, pay later" strategy on a massive scale. The boom in interest-only loans — nearly half the state's home buyers used them last year, up from virtually none in 2001— is the fuel behind California's surging home prices.

But all that borrowed money might be living on borrowed time. If higher bills start coming due, Herron and hundreds of thousands of other homeowners in the state will have to find ways to cope — or will have to sell.

In the most dire scenario, if they owe more on the home than it's worth, they'll simply walk away. Abundant foreclosures could spark a downturn in the entire housing market, leading to the long-feared bursting of what some call a housing bubble.

Interest-only loans, and other forms of so-called creative financing that are far riskier than the traditional 30-year fixed-rate mortgages, have allowed more people to afford homes in California even as prices have skyrocketed.

When the price of houses in California soared 17 percent in 2003 and 22 percent in 2004, a curious thing happened: Instead of homeownership decreasing because fewer people could afford houses, it rose to record levels.

Homeownership up

During the past two years, according to U.S. Census Bureau data, homeownership in the state rose to 59.7 percent from 57.7 percent. The previous record was 58.4 percent, measured during the 1960 Census.

While homeownership in California traditionally lags behind the rest of the nation — the U.S. rate in 2004 was 69 percent — the 2-percentage-point increase during the past two years was greater than in all but about a dozen states.

Rather than closing the door, lenders have apparently been opening it wider, inviting in people like Herron who would not have qualified for a mortgage under the more rigorous standards of an earlier generation.

"If you can fog a mirror, you can get a home loan," said mortgage analyst Ralph DeFranco.

An interest-only loan offers the ability to defer for three, five or seven years any payment for the house itself. That allows a potential buyer to stretch to afford a place that would be otherwise out of reach.

Of course, everyone else using an interest-only loan can stretch, too. The result is that prices keep rising. That, in turn, encourages still more people to use interest-only mortgages, which fuels still more appreciation.

Popular option

In 2001, as the current housing boom got under way, fewer than 2 percent of California homes were bought with interest-only loans, according to an analysis done for the Los Angeles Times by LoanPerformance, a San Francisco mortgage research firm.

By last year, the level had risen to 48 percent. Nationally, LoanPerformance says, interest-only loans were used in about a third of all purchases.

What's propelled the market upward in California, some experts worry, could just as easily speed its descent.

"In the last few years, rates went down and values went up. It's like you were paid to live in California," said analyst DeFranco, who works for LoanPerformance. "People got so used to refinancing. They'd think, 'No problem. My house will be worth twice what I paid, and I'll refinance my way out of trouble.' That's not going to be a good approach going forward."

Here's how he thinks a collapse could occur: Rising interest rates put a brake on price appreciation and refinancings. People realize their interest-only period is coming to an end, raising their monthly payments substantially. Since they have no equity in the house, they choose to default.

"If housing prices go down or even are flat, heaven help us," DeFranco said.

No shortage of bids

The notion of prices falling in California goes so contrary to the current environment it's almost laughable. In the San Francisco Bay Area, probably the state's strongest market, it's routine for houses to get more than a dozen bids. To win a house, a buyer often needs to pay a third over the asking price. A four-bedroom Berkeley house went on the market in February for $985,000 and promptly sold for $1.5 million.

The last statewide downturn in housing came 15 years ago, sparked by large job losses in Southern California's defense and aerospace industries. Nothing like that is happening now. Many experts forecast prices to continue to rise, but more moderately.

Lenders seem reluctant to turn away any potential borrowers, no matter how few their qualifications. At the moment, at least, this is a profitable venture, although by their own admission it is becoming a riskier one, too.

The Federal Reserve regularly queries banks whether they're tightening or loosening credit standards for home mortgages. In four of the last five quarters, standards were loosened. The combined drop was the biggest in more than a decade.

Meanwhile, the range of home mortgage products keeps expanding. Some lenders offer mortgages that are spread over four decades rather than three. Others extend the interest-only period to 10 or 15 years, or offer programs allowing those who have what is called "difficult to document" incomes to put only 5 percent down.

"A few years ago, you would have had to go to an infomercial to get the kind of deals we're offering now," Wells Fargo home mortgage consultant Jimmy Kang recently told a group of new real estate agents.