More than a decade ago a few California lenders came up with a clever idea for borrowers with good credit and a solid payment history: If you like, they said to selected borrowers, you can skip one payment in the coming year.

The beauty of this idea is that it works for both borrowers and lenders. For borrowers, such payment flexibility has value because sometimes finances are tight. For lenders, a single skipped payment means the interest due that month, say $1,000, is not paid -- thus the loan balance increased by $1,000. Do this with thousands of loans and you've created the financial equivalent of many new mortgages with virtually no risk, no paperwork and no closings.

In 2002 Fannie Mae experimented with the Payment Power concept, a loan tried in cooperation with several lenders that allowed borrowers to skip up to two payments a year and up to 10 payments during the life of the loan. Like the payment skipping program a decade earlier, the Fannie Mae program represented a balance between borrowers and lenders, but was more risky because a larger number of payments could be missed.

Now we have a new category of mortgages which offer borrowers a choice of payment options during the first several years of the loan term. The programs differ somewhat but in general terms imagine that an option loan is a 30-year adjustable-rate mortgage for $250,000 with a start rate of 4.25 percent. In the first year the borrower might:

1. Make monthly payments of $1,229.85 as if the loan will be paid off (amortized) in 30 years at 4.25 percent.

2. Make monthly payments of $1,880.70 as if the loan will be paid off (amortized) in 15 years at the 4.25 percent start rate.

3. Make prepayments so the loan will be paid off faster than 15 or 30 years, say $1,500 or $2,000 a month.

4. Make interest-only payments of $885.42 a month.

5. Make payments based on a below-market interest rate, say 1.5 percent. With this option the borrower pays just $312.50 a month -- with $572.92 in unpaid interest added to the debt. ($885.42 less $312.50).

Of the choices above the first three are well within the framework of conventional financing. It's the last two that are squirrelly.

Interest-only loan payments mean the debt is not being reduced. If the option period continues for five years and the interest rate adjusts to 6 percent for the remaining 25 years of the loan, the monthly payment for principal and interest at the start of year six will be $1,610.75 -- a huge increase from the interest-only payments of $885.42.

Is this a problem? Not if the property value increases and the home is sold or the borrower's income has increased. Unfortunately, rising home values and growing incomes are not assured.

As to the 1.5 percent option, if the borrower never makes anything but low payments for five years the loan value will increase by $572.92 per month -- that's an extra $34,375 in principal not counting additional interest on the new and higher debt.

After five years at the low payoff level and as a result of "negative amortization," the borrower will owe at least $284,375, money which will have to be repaid in 25 years. At 6 percent the monthly payment will be $1,832.23 -- a huge increase from $312.50 per month. With interest, the actual payment and debt will be even higher.

Again, if the borrower rolls the dice and the home is sold at a higher value within five years or personal income increases substantially, then everything is fine, But what if home prices do not increase? What if the interest rate goes above 6 percent? What if the borrower is laid off?

There's no question that some borrowers, perhaps many borrowers, will latch on to the low-cost payment with option loans for the entire choice period. And there is no question that some portion of these borrowers, perhaps many, will get burned.

Option loans now allow buyers to bid on properties that otherwise would be unaffordable. Given market trends in the past few years it's easy to understand that people want to have a piece of the huge wealth machine represented by real estate. It's also understandable that lenders want to originate loans, that lender shareholders want more profits and that more buyers mean more competition for homes, thus pushing up values.

I liked the one-payment loan skipping option because it was good for borrowers and represented almost no additional risk for lenders. The "Power Payment" approach was more chancy, but well within the realm of reason.

But option loans are different.

In the next two to four years we'll see elective payments end for many option loans. Then we'll find out who should not have bought and who should not have loaned. Don't be surprised if a lot of cheap real estate floods the market -- and don't be shocked if the value of your home is impacted as a result. As to lender share prices and dividends, how attractive will such companies appear when huge numbers of loans are unpaid, especially if in many cases the size of the debt exceeds the value of the underlying properties?

Alternatively, if we restrict option loans now by regulation or lender choice, the pool of buyers will shrink and home prices will be under far less pressure to go up. We will see less appreciation and even price declines in some local markets. Acting now we may face moderate and tolerable declines in market activity, an opportunity which should not be ignored in the face of the financial calamity which looms ahead.

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