(MONEY Magazine) – AS THE REAL ESTATE BOOM inflated home values all over the country, millions of would-be owners did whatever it took to join the party: bid well over the asking price, hit up parents for a down payment and resorted to ever more creative financing tools, from short-term adjustable-rate mortgages to exotic interest-only option-payment loans. Now that the party seems to be winding down, many of those borrowers are going to be left with a messy cleanup.

As many as 3 million homeowners holding more than a trillion dollars in adjustable-rate debt will face an interest-rate adjustment in the next two years, according to the Mortgage Bankers Association. Assume that adjustment will be in one direction: up. If you shaved your monthly payments by putting off paying principal, your day of reckoning will be that much more intense.

Mortgage rates are at their highest in four years, and with rates on ARMs nearing those on fixed loans, you won't find any easy or cheap solutions. "There are going to be people getting into trouble," says Christopher Cagan, the director of research at data provider First American Solutions. He's found that nearly half of borrowers who took out ARMs in the past year have 10% or less equity in their home, making it hard for them to refinance easily or sell at a profit, especially if prices in their local market have softened.

If you are nervous about what your mortgage payments might look like next year or next month--or have already seen them increase by hundreds--now's the time to do some serious calculations. The decision about whether to refinance is complex--you must factor in your budget, how long you plan to stay in your home, your tolerance for risk and what fees you might pay to get a new loan. The three families you are about to meet are grappling with these issues. Read on to find out how our experts suggest they survive the rate hikes coming their way.

THE HYBRID BORROWER

Locked In, but Not for Long

Two years ago, when Toni Lapp bought a three-bedroom, 1½ bath house in a neighborhood near downtown Kansas City, the divorced mother of two figured this wasn't the last house she'd own. So to buy the $207,500 home, she took out a $162,000 mortgage with a rate that's fixed at 4.6% for five years and adjusts annually after that, giving her a monthly payment of just $833 at first vs. $958 if she'd used a 30-year fixed-rate loan. "I realized, looking back, that I had never lived anywhere longer than six years, so a five-year ARM seemed like a safe bet," says Lapp, 38, a medical writer. But now, less than two years later, she's wondering if that seemingly safe bet was shortsighted.

Today, Lapp is not only thinking of staying longer than five years, she's also considering investing more in her home. With sons Ryan, 13, and Cory, 10, getting older, she feels that her 1,500-square-foot house is too small, and she'd like to have a family room and a second full bath. But worries about her upcoming interest-rate adjustment have left her paralyzed. Already, ARM rates are more than a point higher than what she's paying. When Lapp recently checked the fine print on her mortgage, she discovered that her interest rate could jump as much as five percentage points when it adjusts in 2009, to a rate of 9.6% and a monthly payment of $1,272--a $439 increase. "That was a rude awakening for me," she says. "On top of that, I think about the point I paid for this loan and what a waste that would be if I refinance or sell."

• THE SOLUTION

Stand pat, and hope rates are lower in three years

One thing is nearly certain: Whether Lapp gets a new loan now or later (or sits tight and lets her mortgage adjust), she'll have to write a bigger check someday. If she takes out a 30-year fixed mortgage today, her payment will go up by $180 a month. If she does nothing, her monthly payment could increase far more.

Lapp needs a new mortgage, but when? The answer comes down to mood as much as mortgage rates. Because Lapp is so nervous about paying a higher rate, Tampa financial planner Elaine Scoggins suggests she lock in a fixed rate soon. "She's a single mom raising two kids, so she needs to consider how much stress she will feel as she marches toward the five-year period and sees rates jumping around," Scoggins says.

But if Lapp can stomach a bit of risk, chances are she'll come out ahead by hanging on for a few more years, says Keith Gumbinger, a principal with mortgage data provider HSH Associates. "If she refinances now, she'll lose that nice low rate, and there's no reason to assume that rates will be higher than they are now when she comes up for the adjustment," he says, noting that because mortgage rates have historically moved in five- to seven-year cycles, there's a good chance that in three years they'll be headed back down. Another reason to wait: Lapp isn't sure how long she wants to stay in the home. To cushion the risk, Gumbinger suggests Lapp build up her savings (she recently paid off her car loan, freeing up a few hundred dollars a month). That way she'll have cash on hand to cover more costly monthly payments if rates are higher than they are today when her loan adjusts or she refinances.

The last consideration is Lapp's hoped-for renovation. She's prepared to borrow another $20,000 to add a room and expand the bath. Even though her home has appreciated modestly since she bought it, she doesn't have enough equity to fund the work by refinancing for more than her current mortgage balance and taking cash out. Given that, a home-equity loan (which would cost about $200 a month at today's 8% average rate) is her best option, and she would likely recoup much of her investment in an extra room and bath, even in a slower housing market. Finally, Lapp shouldn't sweat the point she paid on her original loan. Notes Los Angeles financial planner Jeffery Harwood: "That's a sunk cost and irrelevant to the decision about whether to refinance today."

THE INTEREST-ONLY PAYERS

Little Equity, Much Unease

Shortly after they were married, Aaron and Lacey Blank, now 25 and 27, wanted just what you'd expect: to buy their first home and start a family. But like many young couples, the Blanks had trouble scraping together a down payment for a house in pricey Seattle. By the time they found their three-bedroom, newly built home 40 minutes from downtown last year, they had set aside just $16,000. "We weren't planning to buy a place so soon, but we fell in love with the home and the area," says Lacey, a family therapist.

Their stash barely covered 5% of the $330,000 home price, and lining up the financing proved to be daunting. Though Lacey and Aaron, who works in public relations, earn a combined income approaching six figures, their $90,000 in student loans made it hard for them to qualify for a fixed-rate loan. Their solution amounted to a financial high-wire act. The Blanks took out a $271,000 interest-only hybrid ARM with a rate of 6.4% and monthly payment of $1,440 for five years. To cover the rest, they used a $51,000 variable-rate home-equity line of credit. By doing so, they avoided paying for private mortgage insurance (PMI). After taxes, the HELOC's initial $346 monthly payment was less than PMI would have cost.

A flush housing market in Seattle, where home prices rose 15% last year, has bought the Blanks some breathing room; based on recent sales in the neighborhood, Aaron estimates that their home is worth at least $380,000. But that hasn't offered the Blanks much peace of mind because they aren't paying down principal as they'd hoped. "I want to build some equity, but we haven't really been making much headway," says Aaron. The rate on their HELOC has already hit 10.6%, or another $115 a month. The $1,900 Aaron and Lacey spend on their home loans every month is still manageable, but with their first child due any day, they are understandably nervous. In theory, the Blanks could see their mortgage rate jump as high as 11.4% in 2009. Add in principal payments and a 14% rate on their HELOC, and their worst-case scenario is a monthly nut of $3,445.

• THE SOLUTION

Refi with a fixed-rate loan; pay down the HELOC

The Blanks need to lower their interest rates, and their robust local market may help them do that. The couple are paying more on both of their loans than the best rates available a year ago, says Augusta, Ga. financial planner Bill Cleveland, probably because of their student-loan debt and high ratio of debt to home value. Now that price appreciation has beefed up their equity, and they have a track record of on-time payments, they should be able to lower their HELOC rate simply by calling the lender. "I've had clients successfully lower their rate to just over prime by threatening to take their money elsewhere," Cleveland says.

Next up, the Blanks should lock in the rate on as much debt as they can. Taking out a new, 30-year fixed for $304,000 (the full 80% of their current home value) would let them pay off their ARM, shrink their HELOC to $18,000 and start paying down equity. (Many lenders will do a lower-cost refi to keep your business, so ask.) If they qualify for the best rates, they'll be paying $2,050 a month for both loans, an amount they can comfortably swing.

OPTION-PAYMENT HOLDERS

A Risky Loan Gets Costlier

Patent litigator John Ramonetti isn't averse to taking risks. Two years ago, John, 38, and wife Mona, 36, sold their home in Montclair, N.J. and moved to Northport, Long Island, where they felt the schools were better (for kids Adrian, 3, and Emily Jasmine, 6) and they'd be closer to John's extended family. The couple closed on a $700,000, four-bedroom home in December 2004, financing it with 20% down and a loan that could best be described as Exhibit A in the gallery of crazy mortgages: a $560,000 monthly adjustable-rate option-payment loan. Not only does the rate move up or down 12 times a year, but the payment is flexible. The Ramonettis can choose a minimum that doesn't even cover the interest (currently $2,000), an interest-only payment or a sum that covers interest and principal based on a 15- or 30-year loan.

Fortunately, John is averse to debt--he picked this loan because of the low initial rate. "I hate paying interest and fees," he notes. So since taking out the loan, the couple have consistently paid $3,000 to $5,000 a month, enough to cover the 30- or 15-year interest and principal payment, and often more. "I'd really like to pay the loan off even sooner than 15 years," John says.

But lately, chipping away at principal has become tougher. When the Ramonettis got the loan, the interest rate was 4.3%; now it's 6.2%, so a higher portion of each payment goes toward interest. The amount needed to cover interest and principal on a 30-year loan has grown from $2,771 to $3,452. If their rate ever hits its 12.3% max, it could cost them $5,785 a month to cover interest and principal. Recently, John took a look at the history of the index that determines their rate and noticed that in the late '80s and early '90s they would have paid double-digit rates. "I was a little frightened by what I saw," he says. "What is the risk and likelihood of those rates continuing to jump at the current pace? I'm still ahead with this loan. Should I wait and see if rates ease over the coming year or two, and get a better fixed rate at that point?"

• THE SOLUTION

Refinance into a fixed loan

Easy answer: Don't wait. The Ramonettis' mortgage rate is based on the monthly Treasury average index (MTA), which is currently 3.9%, plus 2.35 percentage points. Because the MTA tracks changes in short-term interest rates over the previous 12 months, the rate on their loan is guaranteed to rise by about a point in the year ahead. With rates on jumbo fixed-rate loans only half a point higher than their current 6.2% variable rate, they can lock in a payment ($3,549) for 30 years that's virtually the same as what they pay now--security that's worth the few thousand dollars in closing costs.

If the Ramonettis are willing to lose some flexibility in their budget, they can pay off their debt sooner with a 15-year loan, which comes with higher monthly payments but a slightly lower interest rate. Because the couple aren't planning to move soon, planner Harwood suggests that they consider paying a point in fees to drop the rate even closer to 6%, giving them a fixed payment of $4,712 a month.

Forecast: Pain

THE RISE OF RISKY MORTGAGES

• ARMS RACE The growth of adjustable-rate mortgages means more homeowners are facing rate hikes soon, if not already.

TYPES OF NEW MORTGAGES

• NO PRINCIPAL Buyers have been saving (for now) by paying only interest. These IO loans made up more than a third of mortgages last year, up from a sliver in 2001.

INTEREST-ONLY AS % OF NEW MORTGAGES

• RATE SHOCK Anyone who relied on a home-equity line of credit to buy a home is already paying more.

NOTE: New mortgages include refinancings. SOURCES: LoanPerformance, HSH Associates (hsh.com).

Rising Rates Survival Check List

Staying in your home for a while? Make sure your loan is a keeper.

Refinance now if you have...

• A fixed-rate loan over 8%

• An ARM that adjusts monthly

• A hybrid ARM that starts adjusting within 12 months

Think about refinancing if you have...

• An interest-only loan

• A variable-rate HELOC

• A hybrid ARM that starts adjusting in 12 to 36 months

Stand pat if you have...

• A fixed-rate loan below 8%

• A hybrid ARM that starts adjusting in more than 36 months