It used to be that adjustable rate mortgages -- ARMs -- were a good financial option for many borrowers. Combine low start rates with more liberal qualification standards than fixed-rate financing and ARMs could often be the most attractive mortgage option for many borrowers.

But ARMs have always been a compromise form of financing. Borrowers get some benefits, and so do lenders. For lenders the motivation is less risk: If the cost of money rises over time because of inflation, with ARMs interest rates also rise.

ARM start rates -- which typically last for six months or a year -- are traditionally lower than the interest cost for fixed-rate financing, but consumers give something up for that advantage: The possibility that in the future rates might go up or down. And while rates going down is a joyous thing to behold, rates going up means higher monthly payments.

Because we have enjoyed low inflation since the early 1980s (the prime rate topped 20 percent in 1980 and 1981), ARMs have generally been a good deal when compared with fixed-rate loans. Yes, sometimes rates rose, but they didn't rise enough to cause widespread foreclosures or bankruptcies.

Those low up-front rates are not only important in terms of monthly cashflow, they also have another value: Borrowers can generally get more financing with ARMs.

Lender qualification standards are based in part on interest rates. Borrow $100,000 at 6.75 percent and the lender knows that so many dollars are needed each month for payments. With ARMs, lenders typically qualify borrowers on the basis of the interest rate in the loan's second year, a rate that is often lower than today's costs for fixed-rate financing.

Not only are ARM qualifying rates less than those found with fixed-rate loans in the usual case, lenders also allow ARM borrowers to have more liberal qualification ratios.

For instance, with a fixed-rate loan a lender might allow 28 percent of a borrower's gross monthly income for "PITI" -- the payment of principal, interest, taxes, and insurance. With an ARM, however, the qualifying ratio might be higher, say 33 percent.

Combine lower initial qualifying interest rates with more liberal qualifying ratios, and ARMs allow buyers and those refinancing to borrow far more than might be the case with a fixed rate loan.

For instance, suppose you borrow $100,000 with a fixed-rate loan at 6.7 percent over 30 years. The monthly payment for principal and interest equals $645.28. If taxes and property insurance add another $300 a month, then the total monthly cost for PITI is $945.28. If 28 percent of a borrower's gross monthly income can go to PITI under lender guidelines, it will take a minimum monthly income of $3,376 to qualify for this loan.

But if lender guidelines allow you to borrow with up to 33 percent of your gross monthly income for PITI, and if housing costs again equal $945.28, then you only need a $2,864 monthly income to obtain financing.

ARMs are not a good deal if initial rates are close to rates for fixed-rate loans and that is largely the situation today. Many lenders are now quoting interest levels for fixed-rate loans and ARM financing which are essentially identical.

Equal rates are nice -- but only if there are equal terms. In the case of a fixed-rate loan, you can get 30-year financing with a given rate and a monthly payment for principal and interest that will never change. With an ARM, rates and monthly payments can change and the result is far greater uncertainty and more financial risk.

The terms of trade lenders have offered for ARMs are now largely missing. The deal was a lower up-front rate -- and thus a lower qualifying rate -- for borrowers who accepted ARMs. While the better qualification ratios are still in place with ARMs, so is the risk that rates and payments might rise in the future.

Until ARMs become more attractive up-front, there's little incentive for borrowers to opt for a loan with little financial advantage and greater potential costs than fixed-rate mortgages.

Alternatively, when initial ARM rates return to levels significantly below fixed-rate interest charges, then ARMs will again emerge as a reasonable financial option.

Published: January 9, 2001

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Peter G. Miller, also known as OurBroker®, is the author of six real estate books -- including The Common-Sense Mortgage -- and is the original creator and host of America Online's Real Estate Center. Peter's weekly columns appear in more than 100 newspapers nationwide, he is also published in a variety of other media outlets and he is a frequent speaker at national events and conventions. Peter welcomes your questions, comments, and news releases via e-mail at .