Step away from the exotic mortgage

A lot of homeowners out there are living under a roof they soon won't be able to afford.

By Ellen Florian Kratz, Fortune writer

NEW YORK (Fortune) -- Of all the nonsense that the boom has wrought, little has been crazier than the proliferation of adjustable-rate mortgages, or ARMs, often called exotic mortgages because so few people understand them.

A refresher: ARMs offer a low interest rate - a.k.a. teaser - for a certain period of time, after which it varies according to prevailing rates. To complicate matters further, banks also offer interest-only ARMs that allow borrowers to pay just the interest in the beginning and save the principal for later.

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The most dangerous type is the "option ARM," which causes a home to amortize negatively. That means the borrower pays just a portion of the interest due; the rest is added to the principal. As long as the home keeps appreciating, the borrower keeps his head above water. If the market stalls, an unprepared homeowner can drown.

ARMs have traditionally been the province of wealthy and sophisticated homebuyers. During the boom, however, banks went after anyone with a wallet. As a result, a lot of homeowners out there are living under a roof they soon won't be able to afford.

Worse than that, these poor saps may have no idea what they're in for: According to a study earlier this year by Fed economists, 41 percent of ARM holders do not know the maximum interest rate they might have to pay. They'll find out soon enough, though, because next year an estimated $1.5 trillion worth of these mortgages are scheduled to reset. (By the way, ARMs make even less sense right now given that introductory rates aren't much lower than fixed rates.)

"There's all kinds of language in these ARMs that allow the rate to rise much faster than interest rates are rising," says financial guru and actor Ben Stein. "They can be treacherous. I had one, and it screwed me over."

Here's an example. Suppose a homebuyer obtains a $350,000 mortgage today using a 5/1 interest-only ARM at 6.25 percent. That means the borrower pays just interest for the first five years at the guaranteed 6.25 percent, after which the principal kicks in and the interest rate becomes adjustable. The beginning payment is $1,822.91 per month.

So what happens five years from now when the loan converts from interest only to interest and principal, and the rate faces its first adjustment? Fortune asked Greg McBride of Bankrate.com to calculate various scenarios. Best case: If the rate falls to 4.25 percent, the payment would still rise to $1,896.08 as the principal starts to amortize. If the rate stays at 6.25 percent, the payment rises to $2,308.84. If the rate were to jump to 8.25 percent - which is entirely plausible - the payment would hit $2,759.58.

That's not necessarily the end of it: The borrower could still face further rate increases in subsequent years. "Make sure you can afford the fully amortized payment," says Zelman.

Pat Davis-Lemessy, 44, of Miami Lakes, Fla., knows firsthand how painful these sorts of home loans can be. In 2003, when she purchased her 1,700-square-foot home just minutes away from where she works as a medical plastics engineer for a subsidiary of Johnson & Johnson, she signed up for an interest-only loan with a 3.4 percent teaser for the first four months. At $850 a month, the teaser was easily affordable.

But then her payments started creeping up by almost $200 each month until she found herself paying $1,770 - in interest only! Last year she did the smart thing and refinanced into a 30-year fixed at 5.25 percent. Doing so cost her $5,000 in fees, but she considers that well worth the peace of mind of knowing exactly what she's going to owe each month. "If I'd done a fixed rate when I bought, it would have been 4.65 percent," she says. "The adjustable rate was a mistake. I lost thousands in equity on my home."

6 strategies to survive the bust

Lower your expectations

Drive a hard bargain.

Consider renting

Step away from the exotic mortgage

NEXT: Shop for a rate drop

Keep an eye on your equity

Reporter associate Doris Burke contributed to this article.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.