Here’s the deal: Buy your dream home and pay only interest – no principal – for the next few years. That will give you an unusually low monthly payment while you get on your feet. Or better yet, pick one of our Option mortgages, and pay even less… .

So goes the pitch for the hottest subset of the old-fashioned adjustable rate mortgage. With names like Interest-Only (I-O), OptionARM and Pick-a-Payment, these products offer borrowers far lower payments than they would face with traditional fixed- and adjustable-rate loans. According to some surveys, these especially risky products now account for half of all new mortgages being written this year, up from less than 10% in 2001.

But there’s a catch: The required payment is almost certain to jump a few years down the road — by hundreds and hundreds of dollars a month for many borrowers. In the most extreme cases, the borrower’s debt can actually go up over time, rather than down.

What’s driving this market? Most important: Are these loans ticking time bombs that could shock the financial markets and economy if rising interest rates or falling home values cause a rash of defaults? A flood of failed real estate loans torpedoed the Japanese economy in the early 1990s, and that country has yet to recover.

“The question is: Are we at that tipping point in the United States? And clearly we are not,” says Wharton real estate professor Susan M. Wachter. Nonetheless, she says, these loans are contributing to soaring housing prices, setting the stage for a potentially rough pullback that could make the next recession far more severe than it otherwise would be. “Undoubtedly, these new instruments bring us into uncharted territory. This is unprecedented.”

“Sub-prime” Borrowers

Some types of interest-only mortgages have been around for decades and used by wealthy borrowers who were sophisticated and disciplined enough to find profitable uses for money saved on monthly payments. But today’s products are marketed to ordinary homebuyers and, in many cases, to “sub-prime” borrowers who in the past could not have qualified for standard loans.

Though terms vary, a borrower with an interest-only mortgage typically makes no principal payments during the first five, seven or 10 years. After that, the interest rate adjusts annually based on an underlying benchmark, and the principal payments begin. On a traditional 30-year, fixed-rate mortgage for $100,000 at 5.75%, payments would be about $600 per month. With an interest-only loan, the payment would be about $500, because there would be no principal payment. The lower payment requirement enables the homeowner to borrow more than he could with a traditional loan.

But while the traditional borrower starts whittling his debt with his first payment, the I-O borrower doesn’t. With more debt remaining 10 years down the road, for example, the interest charges will be higher than they would be at that point with a traditional loan at the same interest rate. And the principal payments, once they begin, will be higher with the I-O loan because fewer years remain to pay off the debt.

Since the interest rate may adjust upward after the initial, interest-only period, the monthly payment can soar. The loan that started at $500 a month could easily go to $700 or more – a jump that could exceed 40%. Some borrowers may be unable to meet this burden.

Option loans are similar except that the homeowner has various payment choices every month. A full payment covers interest and principal, as with a traditional loan. The borrower can also make a bigger payment, with the extra going to the principal so that the loan can be paid off more quickly. Then there is an interest-only option.

Finally, there’s a minimum-payment option, which doesn’t even cover all the interest. The unpaid interest is added to the debt, boosting the interest charge. A borrower who routinely chose this “negative amortization” option would end up owing more than he would have originally borrowed. With all four options, interest rates are routinely adjusted, so the interest charges go up if rates rise.

“As interest rates have stayed low, all kinds of lenders and builders are seeking to constantly expand the scope of home ownership,” says Wharton real estate professor Lynn B. Sagalyn. Exotic mortgages allow lenders to reach customers “who otherwise might be shut out of the market as home prices soar at record rates.”

Lenders scrambling for business are also offering loans to people with poor credit, and borrowers can now make down payments of only 5% or 10% – and sometimes zero percent – while 20% was standard not many years ago. “The deeper we get into the pool of what we call marginally eligible borrowers, the riskier it gets” for borrowers and lenders, Sagalyn notes. “That’s something of a time bomb.”

Strong ARMed

Compared to I-O and option loans, the traditional adjustable-rate mortgage looks conservative. With these, the borrower typically gets a low “teaser” rate for the first 12 months. Then the rate changes annually with market conditions. Payments can therefore change every 12 months. But part of every payment goes to principal, as with a traditional fixed-rate mortgage. Because interest rates can change, standard ARMs are riskier than fixed-rate mortgages, though not as risky as the I-O and option loans. The use of ARMs is on an upswing. In the past two years, about a third of all new mortgages were ARMs, according to Todd M. Sinai, real estate professor at Wharton. “They are sort of typical right now,” he says, noting that ARMs made up an unusually low 12% of the loans issued in 2001 but made up half of loans issued in the late 1980s.

Default rates on ARMs have never been a serious problem, Sinai adds. People tend to make mortgage payments their top priority. And since housing prices have tended to rise and ARM borrowers start trimming their debt with their first payments, ARM borrowers who run into financial trouble can generally sell their properties for more than they owe. “The rate of ARM usage in itself is not anything to be particularly alarmed about. I think that they are not as risky as they are perceived to be.”

According to Sinai, loan defaults tend to come amid a “perfect storm” that is rare: Interest rates rise, pushing the ARM payment up; the homeowner’s income fails to rise enough to cover the higher payment; housing prices fall so that the home cannot be sold for enough to cover the debt. He adds, however, that the heavy use of I-O and option loans is so new that no one knows what will happen if interest rates rise and the economy lags. “The banks really don’t know what risks they are taking because these things haven’t been stressed enough.”

This is one of the factors that concerns Wachter. “We do not have the history to test for the likely default rate on these instruments because they are too new.” In the mid-1990s, she says, lenders started using automated underwriting processes to grant or deny mortgages. These proved far more accurate at predicting defaults than the previous subjective system that relied on loan officers’ judgment, allowing loans to less-credit-worthy customers and those with little down payment money. Poorer and riskier customers can now get loans, often by paying higher interest rates that offset the lenders’ risks.

But, Wachter says, lenders don’t have enough data to know just how high the rates need to be set to achieve that balance, and they must keep rates low to compete. The automated underwriting prices have no way of accurately forecasting the risk of I-O and option loans because there’s too little history. “There is a real systemic tendency for banks to support real estate price rises – potential bubbles – when they happen.”

A Market for Optimists

Because home prices have soared in recent years, lenders tend to feel confident that homes will be worth enough to cover the debts of defaulting borrowers who end up in foreclosure.

But why have home prices gone up? Partly because borrowers have lots of money to spend, thanks to low interest rates. The new exotic loans have brought more borrowers into the market, contributing to the price run-up, Wachter says. She believes that contribution to be considerable.

Home pricing, she notes, is not as efficient as pricing on stocks and other securities because only the optimists participate in the market. People who think homes are overpriced sit on the sidelines, allowing the enthusiasts to outbid one another. In the stock market, in contrast, pessimists can bet prices will fall by selling short or buying put options.

In the real estate market, optimists tend to believe prices will continue to go up because they have been going up, according to Wachter. Also, open-space preservation laws enacted in recent years in a number of fast-growing states have made it harder for builders to increase the housing supply as demand grows, helping to push prices up.

Some experts argue that true home-price bubbles are rare, and usually confined to a few overheated pockets. Owners cannot sell homes with the click of a mouse, as they can stocks, so it’s difficult for housing prices to cascade as stock prices do when a bubble bursts. Typically, a home-price run-up is followed by a period of flattening prices rather than a wide-ranging collapse.

But Wachter says some overheated markets in California and the Boston area did see home prices fall by 30 to 40% after the 1980s bubble burst. Prices tend to fall the most where they have previously gone up the most, and many, many markets have seen enormous gains in the past few years. Hence, many parts of the country could experience falling home prices, she argues. “We could have 30 or 40 of those areas instead of one or two.” The risk of borrower defaults is clearly higher because of the heavy use of I-O and option loans, she adds.

While a rash of mortgage defaults is not likely to plunge the U.S. into a prolonged downturn like Japan’s, it would cause lenders to tighten their practices enough to constrain economic growth, Wachter predicts. While it’s impossible to know which lenders and investors carry the most risk because many loans are bundled into mortgage-backed securities and traded on a world-wide market, mortgage defaults could in fact cause losses in mortgage-backed securities, harming many financial institutions and investors across the globe. “If and when the business cycle turns and we are in a recession, the result of this [heavy use of exotic mortgages] is that the recession could be more severe.”