updated 6/7/2005 8:08:04 AM ET 2005-06-07T12:08:04

Once a frustrated renter, Chris Economou is now a happy homeowner, enjoying a splendid view of San Francisco and an $80,000 increase in his property's value since he bought the one-bedroom condominium for $435,000 a year ago.

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He credits his good fortune to an interest-only mortgage, an increasingly popular — and risky — loan that enables borrowers to lower their monthly payments enough for several years to afford rapidly escalating home prices in expensive markets like the San Francisco Bay area. Economou estimates he saves $1,000 a month by having his interest-only mortgage instead of a traditional 30-year fixed rate loan.

"I'd still be looking at renting for a long time," if not for that mortgage, said Economou, 33. "Home prices are so high that it's about the only way young people like me can get into the market."

Video: New mortgage option Built on the assumption that home prices will continue to rise, interest-only mortgages represent a gamble that many home owners accustomed to conventional fixed-rate loans would never take. Unlike conventional 30-year mortgages, interest-only loans typically don't require payments toward the principal for three to seven years, substantially lowering the costs of entry and making it easier to qualify for the loan.

But the financial firepower of interest-only mortgages is affecting all home owners. They are further elevating already lofty housing prices, a trend that's raising fears of crash that could plunge the economy into a recession.

"When this market adjusts, it's going to be painful," said UCLA economics professor Edward Leamer, who has been warning of a California housing bubble for three years. "Borrowers are getting in over their heads, and lenders are too."

The growth of interest-only mortgages reflects a fundamental shift in the way many Americans think of their homes. Rather than places to grow old in, they see homes as part of their investment portfolios — in fact, a much better bet than the stock market in recent years. In California alone, homeowner equity has grown by a whopping $1 trillion since 2000, according to the California Building Industry Association.

Even borrowers who can afford the higher payments of a conventional mortgage are opting for interest-only loans, so they can free up more cash to invest in retirement plans, college education funds or other home purchases, said Mark Carrington, director of information products for LoanPerformance, a mortgage research firm.

"Borrowers are becoming much more educated and smarter about what a mortgage really is," Carrington said. "They are using it as just another investment tool in their overall financial plan."

San Francisco accountant Patrick Duffy advises his clients to use interest-only mortgages, unless they plan to live in a home for at least seven years. "If you are only going to have it a short time, why waste your money" on the higher monthly payments required under a conventional 30-year mortgage, reasons Duffy, who financed both his homes with interest-only loans.

With some of the nation's highest home prices, California has become ground zero for interest-only mortgages, especially in the San Francisco Bay area, where more than half of home buyers have financed their purchases with interest-only loans since the end of 2003, according to LoanPerformance.

Large numbers of home buyers also have been relying on interest-only mortgages in hotter markets in Florida, Nevada and Arizona, according to the market research firm.

The home buying frenzy reminds Yale University economics professor Robert Shiller of the mania that gripped the stock market during the Internet-driven boom of the late 1990s — an era dissected in his book, "Irrational Exuberance," released in March 2000.

Shiller recently released a second edition with a new chapter warning that the housing market is creating the same kind of investment bubble that led to the stock market's three-year meltdown.

"This is new territory for the real estate market," Shiller said in an interview. "There's been a major attitude change that's caused people to become very speculative about home prices. All the fear (of a market correction) seems to be gone."

A sharp downturn in housing prices could turn interest-only mortgages into financial albatrosses, saddling many borrowers with homes worth less than what they owe.

Also risky are the adjustable rates included with many interest-only mortgages. If the prime lending rate continues to rise, these homeowners' monthly payments could soar even as home values plummet.

A double whammy like that would increase the chances of borrowers falling behind on their payments or, in the most extreme cases, just walking away from their homes, raising the specter of the massive foreclosures that contributed to the taxpayer-backed bailout of the savings-and-loan industry during the late 1980s.

Federal banking regulators are so concerned that they're talking openly about regional housing bubbles and considering new guidelines for lenders to guard against taking on too much risk, said Steve Fritts, acting deputy director of the FDIC's Division of Supervision. "There are people who are pushing the envelope," he said.

Interest-only mortgages have been a boon for buyers so far because home values in most places have surged so much that borrowers are getting richer — on paper at least — even as the amount owed on their loans remain the same.

For instance, the median sales price area of an existing single-family home in the San Francisco Bay Area was $689,200 through the first three months of this year, a gain of 45 percent from $475,900 at the end of 2001, according to the National Association of Realtors.

Put another way, someone who bought a mid-priced Bay Area house with an interest-only mortgage in 2001 conceivably could be sitting on a $213,300 gain in home equity — enough to buy a house outright in many parts of the country — before repaying a cent of the original loan.

Economou, who is a commercial real estate broker, already is looking ahead to mid-2007 when his loan will start to require principal payments. By then, he hopes to have accumulated enough equity in his condo to be able to sell it and to buy a bigger home.

"Of course, I would hate to see my home's value drop significantly, but I think this is a chance worth taking," Economou said. "It's been a pretty good bet so far."

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Data: Latest rates in the US

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Home equity type Today +/- Chart
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