01:00 AM EDT on Sunday, April 10, 2005

BY ALBERT R. CRENSHAW
The Washington Post

There has been plenty of wailing in recent months over the soaring property tax bills that homeowners have been receiving, thanks to their similarly soaring home values. Families complain of being "taxed out" of their homes through no fault of their own.

But less attention is being paid to a group of homeowners who could be in even greater peril: those who stretched themselves thin to buy an expensive house that they could afford only by borrowing on a low-interest, adjustable-rate mortgage.

Interest rates now appear to be starting back up, and many of these borrowers will soon face higher mortgage payments, often accompanied by those higher taxes.

It's hard to tell exactly how many such homeowners there are, but if the popularity of adjustable-rate mortgages is any indication, there are a lot.

According to an analysis by Barry Glassman, of Cassaday & Co., a McLean, Va.-based financial advisory firm, adjustable-rate mortgages (ARMs) last year took a startlingly large share of the mortgage market, accounting for roughly a third of new originations for much of the year and topping out at 36 percent in October.

That finding is counterintuitive. One would think that as fixed-rate loans reached lows unseen in decades, borrowers would be hurrying to lock them in. After all, if you miss and rates keep falling you can always refinance. The time to take an ARM is when rates are high and you think they will fall.

One worrisome possibility is that the surge in ARMs reflects buyers stretching to the limit to buy a house they can barely afford, or to buy any house before prices, which have been rising faster than incomes in many markets, leave them permanently behind.

"Not too many things make me nervous, but this does," Glassman said.

Interest rates on mortgages that adjust annually, known as one-year ARMs, typically run between 1.5 and 2 percentage points below 30-year fixed-rate mortgages. Rates on one-year ARMs last year ranged from a low of just over 3.5 percent to 4.18 percent in December, according to data from Freddie Mac, the giant mortgage finance company. For February of this year, the rate was 4.16.

For all of last year, one-year ARMs averaged 3.9 percent, and for 2003 they averaged 3.76 percent.

Thirty-year fixed-rate mortgages averaged 5.84 percent last year and 5.83 percent the year before.

At those averages, the monthly payment on a $250,000 one-year ARM would be $1,179.17, while on a fixed-rate loan it would be $1,473.26. So the appeal to a borrower who is near the limit of his or her ability to pay is clear.

But recent economic reports suggest that inflation may be accelerating, and Federal Reserve Chairman Alan Greenspan has made it clear that he intends to raise interest rates as aggressively as necessary to keep inflation in check. So far, the Fed's pressure has not caused dramatic changes in mortgage rates, but if rates return to the levels that might have been considered reasonable just a few years ago -- say, 7 percent or 8 percent -- ARM holders would face big payment jumps.

At 7 percent, the payment on that $250,000 ARM would be $1,663.26. At 8 percent, it would be $1,834.41.

A large number of ARM loans when rates are low "is a little worrisome," said David Lereah, chief economist at the National Association of Realtors (NAR) in Chicago. "It does indicate there are households out there at the margin leaning heavily on ARM rates to qualify for the house."

But Lereah said the overall reality is very complicated.

First, he said, an NAR survey conducted a month ago indicated that 36 percent of all recent homebuying involved second homes. "That raised eyebrows" because the figure was so high, he said.

It suggested that "there is certain segment of real estate investors getting more involved in speculative buying," speculative in the sense that "they are basing their investment on what may be an unreasonable expectation of future prices so that when you look at cash flow it's negative," perhaps even with an ARM at present low rates, "so they are completely depending on the price increase" for a profit.

But while this group has been getting headlines, it remains small relative to the overall market, Lereah said.

Second, many second-home buyers are paying prices in line with the past, he said, adding that many of these buyers, having seen their equity soar in their first homes, have been able to cash in some of that through refinancing and buy their second homes for cash or with big down payments.

Families who have an ARM, and who plan to remain in their house for a long time, should think about refinancing it if they can. Rates remain fairly low even after a couple of bumps, and once you have locked in a loan whose payments you can afford, you will in an odd way have put inflation on your side. Your loan payment doesn't change -- at least not the principal and interest part -- and as your income rises with the passing years, the payment shrinks relative to your paycheck.