Buyers bet the house with risky interest-only loans.

Increasing numbers of L.A. homeowners are taking out mortgage loans with low initial payments and high back-end payments, making a huge bet that housing prices will keep rising sharply.

If they are wrong and the housing market slows, not only could they be wiped out financially, but they could take a major chunk of the local economy with them.

Forty-two percent of home purchases in L.A. County so far this year have used interest-only loans--an all-time high since such mortgages were introduced about three years ago--and more than 50 percent above the national average, according to data compiled by Loan Performance, a unit of Anaheim-based First American Real Estate Solutions L.P. More than one-fourth of all home loans, including refinancings, are being issued with interest-only payments.

"There's a big risk here, especially for people who bought recently at what may be the top of the market," said Celia Chen, director of housing economics for Economy.com, a West Chester, Pa.-based economic consulting firm.

Interest-only loans offer enticing low monthly payments for the first three to seven years, often allowing people to buy homes they might not otherwise be able to afford. During that time, homeowners do not have to pay down the loan balance--making payments easier at a time when average home prices have topped half a million dollars in many parts of L.A. County.

But once the borrower begins paying down principal, the payments rise substantially. If home prices stagnate or decline, borrowers could find themselves in an "upsidedown" position, increasing the risk of a default.

The spillover effects could result in lower consumer spending and a general tightening of credit as lenders face higher bad loan ratios.

There is anecdotal evidence that interest only-loans are beginning to drop in popularity now that long-term interest rates have fallen to near record lows. "Long term rates are now so low that people are asking how they can get out of their interest-only loans and into fixed-rate long-term loans," said Mitch Ohlbaum, an L.A.-based mortgage broker.

There is also skittishness about the state of the housing market, as talk of a housing bubble permeates the media. Chen said that the baseline economic forecasts call for a housing slowdown starting late this year or early next, but not an absolute nationwide decline in housing prices.

Other economists say that the nation is in a housing bubble that is about to burst; citing the recent rapid run-up in prices that has far outstripped the rise in incomes.

Valuable tool

The median home price in L.A. County in May was $459,000, up 16.5 percent from one year earlier, according to DataQuick Information Systems. Total personal income growth in Los Angeles County in 2004 was 5.9 percent, according to the U.S. Bureau of Economic Analysis.

This disparity is one reason borrowers have flocked to interest-only loans. Buying a home can be a stretch for first-time homebuyers, and the loans have also been popular with investors buying homes with the intention to sell in a few years at a profit (a practice known as "flipping").

"These loans enable borrowers to qualify for the homes they wish to buy," said Bob Visini, vice president of marketing for Loan Performance. "They are also for people who don't want to be spending too much of their monthly cash flow on house payments--at least for the short-term."

Interest-only loans can be a valuable tool in an increasingly mobile society where the average length of stay in a home is six years. If a homebuyer plans to trade up (or down) to a different home in five or six years, the prospect of lower monthly payments for most of that time period would seem to make sense.

But if the home loses value during that time, then the homeowner is less likely to Sell at the end of five or six years, leaving them stuck with the higher back-end payments they did not initially intend to make.

Interest-only loans have been particularly widespread in California's coastal areas, where home prices have soared beyond the reach of most residents.

In the Bay Area and San Diego, more than half of all home purchases were financed with interest-only loans last year and again this year, with Orange and Ventura counties not far behind, according to the Loan Performance data.

Nationwide, 31 percent of homebuyers used interest-only loans last year. That has slipped to 26.8 percent through April thanks in large part to the narrowing spread between short-term and long-term interest rates.

Lower Payments

Percent of home buyers choosing interest-only loans.

                     2003      2004       2005 *

L.A. County          17.1%     40.1%     42.0% *
Orange County        23.8%     49.3%     44.0% *
San Diego County     37.7%     62.8%     50.0% *
National Average     13.4%     30.9%     27.0% *

* Through April

Source: Loan Performance, a subsidiary of First American
Real Estate Solutions LP

Note: Table made from bar graph.