High rates let air out of housing market Adjustable mortgages undergo big swings

When Jerry Steach bought his South Beach condo in the spring of 2004, he figured he'd sell it several years later. But the payment on his adjustable-rate mortgage has soared nearly 60 percent, and Steach now hopes to unload the property early next year.

Bay Area borrowers are starting to feel the sting of steadily rising mortgage rates -- a trend that could dampen a housing market already showing signs of moderating, according to economists.

After hovering near historic lows through much of the spring and summer, rates for both long-term and short-term mortgages have climbed markedly during the past two months, taking a bite out of buyers' borrowing power and forcing Steach and others to re-evaluate their financial plans.

In particular, those with adjustable mortgages -- in which payments float up or down periodically depending on the direction of short-term interest rates -- have seen big swings in the past 12 months or so.

"I knew (rising rates were) a possibility, but I didn't know it was going to be maxing out," said Steach, a consultant to technology companies. "It's not the only reason I'm selling my condo, but it solidified it."

Last year, Mike McConnell and his wife, Jeri Lynne Jones, refinanced the fixed mortgage on their Foster City condo to an interest-only loan with the aim of gaining a little more financial flexibility. Their payments plunged from about $2,500 to around $1,800 overnight.

As the mortgage rate adjusted upward each quarter, however, the payment jumped to $2,700 in relatively short order. Less than a month ago, they refinanced again -- back to a 30-year fixed-rate mortgage. The payment is the same, $2,700. But, unlike the interest-only loan, a chunk of that payment is principal. And they know their payment won't change.

"We thought (payments on the interest-only loan) were going to stay low," McConnell said. "Then, over the last six months, we thought if we're going to get back to something more stable, we need to make a move."

McConnell, who owns a 35-employee hair salon in the Stanford Shopping Center, was fortunate.

The benchmark 30-year fixed mortgage, the preferred loan for generations, is not an option for many borrowers whose only chance to get into the high-flying real estate market these days is an adjustable loan. Around the Bay Area, about 80 percent of new home buyers are taking out adjustable loans as opposed to less risky fixed-rate loans -- about double the rate of two years ago, according to market research firm DataQuick.

Adjustable loans have practical advantages -- such as lower initial monthly payments, and lower rates. But in recent weeks, the differences between short- and long-term rates have narrowed. For instance, the one-year Treasury-indexed ARM averaged 5.2 percent last week, up from 4.17 percent last year, according to mortgage titan Freddie Mac.

The 30-year fixed-rate mortgage, meanwhile, hit 6.37 percent last week, up from 5.74 percent last year.

With fewer options to help them keep monthly payments manageable, some borrowers may be painting themselves into a financial corner.

In particular, riskier negative amortization loans are growing increasingly popular, local mortgage brokers say.

Under the terms of these types of loans -- also called option ARMs -- borrowers can choose one of four different payments each month. By forking over the smallest payment, borrowers cover less interest than what accrues on the loan. Over time, if a borrower continues to pay only the minimum, the unpaid interest is added to the back end and their loan balance can grow. If interest rates rise, the balance can grow even faster.

When Yvonne Garnett bought her brand-new condo in Oakland's Laurel district earlier this year, she planned on using an interest-only loan with a rock-bottom teaser rate for a few months and then refinancing to a five-year fixed adjustable. But when the introductory period ended and her monthly payment jumped from $2,000 to $3,000, the five-year adjustable rate was too high.

Instead, she moved to a negative amortization loan, bringing the minimum payments to a reasonable $1,600. Garnett, a consultant to chiropractic practices, isn't worried she'll come to depend on paying only the minimum. That's because her income spikes at different points in the year, allowing her to pay off more of the loan.

Garnett may be the exception, however. Concord mortgage broker Bruce Honaker said 6 out of 10 respondents to a recent advertisement are calling up to get out of their adjustable mortgages. The only option for many is the negative amortization loan.

"Those loans are OK for cash flow, but if you're doing it because you have to ... those people aren't going to come out ahead," Honaker said. "They're going to get into a pattern of refinancing every three or four years back into those loans, and they're not going to build equity."

Some real estate experts worry that as interest rates rise, many owners will be forced to sell, adding more inventory to a market already showing signs of cooling off.

"Even for two-income earners, there's not a lot of room for error in their budget," said Rick Harper, director of housing for Consumer Credit Counseling of San Francisco.

If interest rates keep rising, "they're posed with the problem of where do you go now?"

What are people saying about mortgages today:

Rates on 30-year mortgages edged down last week to a seven-month low. Mortgage-giant Freddie Mac reported Thursday that 30-year, fixed-rate mortgages fell to 6.3 percent, down slightly from 6.31 percent two weeks ago. It put rates at the lowest level since they were at 6.24 percent the first week of March.

Bank of Hawaii, Central Pacific Bank, Territorial Savings Bank and Wells Fargo Home Mortgages all cut their 30-year mortgage rates to 5.75 percent this week.

Most people think of a mortgage as a means to an end. After all, you buy a house, not a home loan. But a mortgage is much more than the path to homeownership. It is a financial instrument that must be managed, just like any other financial investment.