With the economy facing a

Fed

tightening cycle, why is a growing percentage of prospective homebuyers gambling on adjustable-rate mortgages?

The odds would seem to be against such a bet, with fed funds all but certain to rise this summer and fixed-rate loans still carrying historically low rates just above 6%.

Still, about 35% of all mortgage applications are for those with rates that fluctuate with the market, the highest such percentage in almost a decade and more than double the rate of 2003.

The temptation and inclination may reflect cost. Currently, adjustable-rate loans carry average yearly interest of 3.87%, compared with about 6.32% on a 30-year fixed. The spread -- which typically widens when fears of a rate hike grow -- could easily close up and reverse, however, when the rate is recalculated, with that low rate turning into a much higher rate.

The recent spike in the number of buyers taking these loans indicates many people are confident that an adjustable-rate mortgage won't become a huge burden later, either because future rates may not be that much higher-- or possibly even lower -- or they plan to sell the property before the low introductory rate expires.

Last week, the yield on the 10-year Treasury note, the main gauge for mortgage rates, was at 4.60%, nearly a full percentage point higher than in mid-March. Fixed-rate mortgage rates largely reflect that surge and are at their highest level in nine months.

The cost of adjustable-rate mortgages, or ARMs, has risen as well, though not nearly as much. According to the Mortgage Bankers Association, an industry trade group, the average adjustable rate of 3.87% is just 24 basis points higher than a year ago.

When the Fed finally moves, mortgage rates will continue to rise, according to Doug Duncan, chief economist for the Mortgage Bankers Association.

"Our forecast has for some time anticipated that the Fed would wait until late this year before starting to raise short-term interest rates," Duncan said. "But the growth of the economy has accelerated and raised the likelihood of a near-term rate increase."

What a Difference a Year Makes

Based on the national average home price of $170,000, minus a 10% down payment, a $153,000, 30-year fixed rate mortgage at 6.32% would mean monthly payments covering principal and interest of $949.02. The same payment during the fixed term of an adjustable rate mortgage at 3.87% is 719.03, a 24% difference.

And in a housing market where new home prices are rising 5.5% this year and are expected to rise about 4% in 2005 and 2006, that helps stretch a buyer's reach

The danger is in the adjustment, which typically occurs after an interval of one, three or five years. For instance, in three years, if rates move to 8.6%, the monthly payment would leap to $1198.19; that's almost 40% more than the introductory rate payment on the ARM and 25% more than the monthly payment on the fixed-rate alternative.

Although conventional wisdom in the real estate industry suggests people move every seven years on average, meaning many properties bought on ARMs will turn over before rates rise, at least some of those buyers will overreach. That will contribute to a projected rise in foreclosures like the one that followed the spike in ARMs from 1994 to 1995 -- when the Fed essentially doubled the funds rate -- says Alexis McGee, president of Foreclosures.com, a distressed property investment advisor.

In part, the trend toward adjustable rates reflects homebuyers' refusal to temper their rabid appetite for real estate, sometimes at any cost. With buying power down, people are choosing an initially cheaper interest rate in order to come up with the money they need to make an offer, particularly in expensive markets, says Lawrence Yun, chief economist for the National Association of Realtors.

"Once a buyer identifies the home they want to bid on, it's hard to back down just because the rate has risen," he says. "Now with some home buyers unable to obtain the same loans at the higher rate, they'll be seeking an alternative, and the only recourse available is the lower-rate adjustable."

An ARM is cheaper, but it's not always right for every buyer.

McGee says many buyers, particularly first-time ones who will likely move within five years, can do well with an ARM. The most vulnerable are buyers without the income to meet the higher payments after over-leveraging themselves with bigger loans at attractive ARM rates.

"To be fiscally responsible, you would not necessarily borrow the maximum you can at an ARM rate," she says. "It's inevitable that the rate will go up and then it's more than you can afford. That's just not smart."

"It tends to be a very personal decision," says Walter Maloney, a spokesman for the National Association of Realtors. "If you know you're going to move within the next five years, it might make a lot of sense to have an ARM. That's particularly true for first-time buyers who anticipate a rise in income."

The threat to buying power represented by a rising interest rate is substantial, notes Melissa Cohn, owner of the Manhattan Mortgage Co. She says average 30-year fixed rates for the New York metropolitan market have jumped nearly 1 percentage point in two months.

Every one-percentage point increase in interest rates mean a 10% drop in buying power. For instance, the $1,798 monthly payment on a $300,000 mortgage at 6% goes up to $1,995 on a 7% note. That's a big difference.

"As rates go up, more and more people are going to go to an adjustable rate to qualify

for a mortgage and afford their home," she says. "But if you're going to be there the rest of your life, even though fixed rates aren't as low as they were, it's still not a bad opportunity."

In Cincinnati, where the average house costs around $160,000 -- $10,000 less than the national average -- real estate agent Terry Hankner says most buyers are taking what the fixed-rate market offers.

"We're still at 6.25% for the 30-year fixed, and that's still pretty attractive, because housing prices are still affordable," she says. "This little pickup of interest rates hasn't put anybody in the adjustable-versus-fixed mode yet."

A sense of security influences the choice, says Ruth Kennedy, a broker in Fort Myers, Fla., where the average housing cost is about $170,000, in line with the national average.

"There's nothing wrong with adjustables, but most people here get real nervous about them," she says. "The people who do adjustables are people who are more secure, and they'll kind of take the gamble. They can do something about it if it gets out of control later."

Jason Potts, a broker at Tomasso Mortgage in nearby Cape Coral, says initial interest in ARMs often turns to welcome relief at getting relatively low fixed rates.

"I don't have a crystal ball and neither do they," he says. "People call and right off the bat request an ARM, and when I look at their assets, I'll discuss fixed-rate mortgages, because they will know that rate and the payment will not change."