Almost one year after they bought a Hoboken, N.J., condominium, Dana Defonte and Michael Olin haven't paid off a penny of the principal.
"We wanted to keep our monthly payments down," said Defonte, a copywriter.
So the couple took an interest-only mortgage, an increasingly common type of financing that allows borrowers to postpone principal payments. In their case, monthly payments are about $150 lower than they would be with a conventional mortgage -- for now.
But today's low payments come at the cost of higher payments later, when borrowers will have to start paying off the principal.
Defonte and Olin say they aren't worried about payment shock, in part because they expect to sell their condo before 2009, when they would be obligated to start making payments on the principal.
But homeowners who use interest-only loans and stay put long enough could face a jump of $500, $1,000 or more in their monthly payments. Typically, the increase begins after five years.
"If you're stretched to the max to be able to make the interest-only payments, the question is: What are you going to do when the principal comes due?" said Doug Duncan, chief economist of the Mortgage Bankers Association in Washington.
Many housing experts fear that interest-only loans and other creative loans are letting some people buy more house than they can afford.
Among these loans are adjustable-rate mortgages, which offer low interest rates in the beginning, though they later adjust to market rates. Also on the rise: no-down-payment loans and "option ARMs," which allow buyers to vary their monthly payment. With all these loans, costs are lower in the beginning but risks are higher later on.
"People feel that the house will appreciate, so they're going to build equity that way," said Steve Graber, president of Pan American Mortgages in Saddle Brook, N.J. "Instead of living in an apartment, instead of buying an inferior house, they were able to buy the house they wanted" by using creative loans, he added.
Nationally, interest-only and adjustable products made up 63 percent of mortgages written in the second half of 2004, according to the Mortgage Bankers Association.
But some of these buyers may soon find that they're in over their heads. "The worry is that when the interest-only feature is done, there's going to be a huge default rate," said Robert Wilderotter, executive vice president of the Real Estate Mortgage Network in River Edge, N.J.
The risk is greater if, as many fear, the housing market is a bubble about to burst. Alan Greenspan, chairman of the Federal Reserve Board, told Congress in June that interest-only loans were contributing to "froth" in housing prices. "There's a certain amount of mania in the market," said Keith Gumbinger of HSH Associates, a Pompton Plains, N.J., company that tracks the mortgage market.
If property values deflate, homeowners who turned to creative financing could find themselves owing more on their mortgages than the house is worth, Gumbinger said.
Another concern is that mortgage rates, now near historic lows, will only go up. So homeowners could face a big hit when their adjustable loans start adjusting to market rates. Worse yet, the higher rates might hit at the same time homeowners have to start repaying the principal. "You could find a double whammy on your payment," Gumbinger said.
Some buyers think that when that happens, they'll just refinance. But Gumbinger said: "You might not be able to get a favorable interest rate. You might be able to refinance, but your rate goes up 2 percent."
Some buyers say that if they can't face the higher payments, they'll just sell. But if a lot of borrowers are in the same circumstance, Gumbinger said, "you might be putting your home on the market when a whole lot of people have to do so, as well," which would depress prices.
Many of these buyers would be better off renting, Gumbinger said. But if they do take creative loans, he advises, they should set aside some of their extra cash flow every month in preparation for the day when payments will rise.
"At some point, the higher payment will come due," he said.
But he says he suspects many home buyers are not doing this; instead, the money freed up by lower mortgage payments is going toward cars and vacations. In fact, Gumbinger and others say many buyers may not really understand the creative mortgages they're getting.
Getting a mortgage is a lot more complicated than it was 20 years ago, when loans came in just a few flavors: fixed or adjustable, 15-year or 30-year. Now, faced with an array of choices, many buyers' "eyes glaze over," Gumbinger said.
Paradoxically, creative mortgages are becoming more popular at a time when traditional fixed-rate mortgages are available at bargain rates -- under 6 percent. Locking in a rate like that would mean that the lender, not the homeowner, would carry all of the risk of rising rates for three decades.
The mortgage lenders interviewed all said they try to protect buyers from the risks of creative loans by making sure they understand the loans and that the loans are suited for them.
Wilderotter says he likes 10-year interest-only loans, which give more time for salaries and home values to grow before the principal must be repaid. "Time tends to cure a lot of issues," he said.
Duncan summed it up: "Your decision on your mortgage should be part of your overall financial planning."