When the price of houses in California soared 17 percent in 2003 and 22 percent in 2004, a curious thing happened: Instead of homeownership decreasing because fewer people could afford houses, it rose to record levels, shows an article in the LA Times. In his LA Times article, writer David Streitfeld links the rise of home prices and home ownership to one thing.

The interest only mortgage:

Interest only mortgages give homeowners the option to pay only the interest of the loan for a specified time period, usually 3,5,7, 10 or 15 years. Since the first few years of any home loan are mostly interest anyway, the loans are actually designed to allow home owners to put away the extra cash. At the end of the initial interest only period, the loan then converts to a fully amortized loan.

For example, the monthly payment of a standard 30 year mortgage at 6.25% would cost $1231 per month, the same loan at interest only costs $791.

In Californias housing market, home buyers are affording more home because of the interest only loan. They are playing the buy know, pay later game. The lower payments of the interest only loan allow buyers to afford more home for less. The notion of prices falling in California goes so contrary to the current environment it's almost laughable. In the San Francisco Bay Area, probably the state's strongest market, its routine for houses to get more than a dozen bids. To win a house, a buyer often needs to pay a third over the asking price. A four-bedroom Berkeley house went on the market in February for $985,000 and promptly sold for $1.5 million. "If property values continue to rise, the interest only homeowner builds equity in the home without paying down any principal.

In a surging housing market, the gamble is quite lucrativepay interest only for 10 years, allow the market value to appreciate, gain equity without paying any principal, then refinance or sell to get the return from your investment. But if the FMV of the home doesnt appreciate or actually depreciates, homeowners could get stuck in an unfortunate situation.

"Of course, there's never a guarantee that prices will appreciate. And if you stay in the house longer than you planned, your monthly payment jumps drastically after your five-year honeymoon period. Suddenly you have to pay principal on the loan, and most likely at a higher rate. If your rate goes to 7 percent for the life of the loan (and there's nothing stopping it from going higher), your payments will nearly double to $1,413."

In the most dire scenario, if they owe more on the home than it's worth, they'll simply walk away. Abundant foreclosures could spark a downturn in the entire housing market, leading to the long-feared bursting of what some call a housing bubble, shows Streitfelds LA Times article.