Rising mortgage rates can house financial peril

ortgage rates last week hit their highest point since September 2003, which means homebuyers should brace for higher monthly payments. On the other hand, rising rates may be a breath of fresh income to retirees relying on interest payments.

That's the Jekyll-and-Hyde effect of rising rates since the Federal Reserve began raising them in quarter-point bumps a year and a half ago. This month's federal funds rate increase to 4 percent was the 12th in a row -- and more are probably on the way, the Fed warns.

This week and next, we'll look at the opportunities and traps rising rates present for home borrowers and savers.

Until recently, mortgage rates, which track 10-year government bonds, haven't taken the same upward trajectory as short-term interest rates controlled by the Fed. It looks as if long-term rates are now ready to play catch-up and could squeeze borrowers who've been relying on market appreciation rather than principal payments to build home equity. So far in Portland's real estate market, where double-digit annual appreciation has been the norm, that's been a good bet.

But people who've stretched to buy a house by coupling no-down-payment loans with interest-only monthly payments could be in for a shock when Portland-area real estate eventually cools. It won't take a total collapse in real estate prices, just a decline in the growth of appreciation, to put some homeowners in one heck of a bind.

Ken Minn, loan officer at Portland's First Horizon Home Loans, explains how. A borrower with a $200,000 zero-down, interest-only loan has a house payment that is about $200 lower per month than if he were paying principal, too. The lower payment qualified him to borrow more than if he were paying principal.

If real estate prices increase 20 percent, and he sells next year, he pockets $40,000, minus sales costs of $16,800.

"But if values start tanking and you're not paying down principal, you can get hurt," Minn says. "If the value drops, say, to $190,000, now you're in a negative equity situation. If you have to sell, you have to come up with $10,000 at closing plus 6 to 7 percent in commission and closing costs."

What if you have to stay in a home you thought you'd sell? If you paid 5.75 percent interest -- but no principal -- for the first five years, your payment on $200,000 would start at $1,167, but jump to $1,258 in the sixth year when the principal kicks in. If your interest-only loan is adjustable, the new rate after five years could be much higher. At 7.5 percent, your payment would be $1,478.

"That's the concern out there," Minn says. Although half his clients still choose the safety net of a fixed-rate, principal-and-interest loan, "a good 30 percent of my borrowers are opting for interest-only loans." Most of them are putting 10 percent to 20 percent down, though, so they have some equity as a cushion.

"In Portland, the probability of the market tanking is pretty slim," he says. Nevertheless, borrowers who already have or are considering zero-down loans with interest-only options should know the dangers. If they haven't already, borrowers should talk to their lenders about worst-case scenarios -- and plan for them.

The most important question to answer about any mortgage, Minn says, is how long you intend to have it. If you'll be in your home for more than seven years, a fixed-rate 30-year or 15-year mortgage is still the best deal for most people, because they'll be locking in a relatively low rate and building equity over time. The average rate nationally on a 30-year fixed loan last week was 6.36 percent; the average for a 15-year mortgage, 5.89 percent.

"Rates are up slightly, yes," says Mark Haldeman of Wells Fargo Home Mortgage in Portland. "But they're still quite attractive." Even if the 30-year fixed rate goes to 6.5 or 7 percent next year, he said, "historically, that's not too bad."

If you'll be in your house for less than seven years, the ideal mortgage could be a five-year or seven-year hybrid adjustable. The hybrid, which fixes interest for the first five or seven years and adjusts annually after that, is the most popular mortgage in the Portland market because it's relatively safe and it's cheaper.