Mortgage rates have risen considerably in the last couple of months. Back in November, interest rates for 30-year conventional financing was as low as 6.25 percent with no points. Today, expect to pay about 6.75 percent.

Don't get me wrong -- rates are still low relative to what we have seen in the past and a lot of folks can still save money by refinancing. And 6.75 percent isn't a bad rate for those looking to buy a home. Nonetheless, a .5 percent rate hike in two months is a substantial short-term jump.

As fixed rates rise, good loan officers seek out other mortgage programs that may meet their customers' needs. Given today's interest rate environment, one option might be the LIBOR adjustable-rate mortgage (ARM).

This is a complicated mortgage program but can be a great product for certain borrowers. Here is basic information to help you better understand how it works.

LIBOR is an acronym for London InterBank Offering Rate. Specifically, the LIBOR is the rate that international banks based in Europe charge each other for overnight funds.

What's important is that the LIBOR rate is currently sitting pretty at less than 2 percent for the one-, three-, and six-month indexes. The 1-year LIBOR index is above 2 percent.

With adjustable-rate mortgages -- ARMs -- the monthly rate and payment can move up and down. In general terms, the interest rate for an ARM is determined by an "index" that moves with economic conditions and a "margin." The margin is a set figure which is in addition to the index. There are several types of indexes commonly used by lenders, including measures based on the movement of treasury bills, the 11th District Cost of Funds, and the LIBOR rate.

Here's what I'm getting at. Adjustable Rate Mortgages (ARMs) that are tied to the LIBOR index are a bargain these days. To illustrate, let me describe an actual LIBOR ARM that's available through various lenders and brokers across the country: The program takes the current one-month LIBOR rate of 1.87 percent and adds a 2.25 percent margin. These two items equal the interest rate: 4.11 percent. Pretty low.

The loan carries no points or origination fees. This means you only need to pay typical closing costs such as appraisal fees, county recording fees, etc. Any adjustable rate must come with low closing costs, otherwise big expenses at settlement will offset the benefit of the low rate. Since one "point" is equal to 1 percent of the loan amount in cash, you can see that any loan with points can get expensive very quickly.

This interest rate is not a "teaser rate". A lot of ARMs come with a temporary introductory rate for a few months. After the introductory period, the rate spikes. This program starts and finishes at the one-month LIBOR rate plus 2.25 percent.

The loan has several caps: The maximum lifetime interest rate cap is 13 percent. The most monthly payments can rise is 7.5 percent annually. Borrowers can repay the loan in three ways:

• With a fully amortized monthly payment so that the loan is paid off in 30 years.

• With a minimum payment. This assumes the interest rate is 2.95 percent. Such a payment schedule would normally produce "negative" amortization, meaning that the some of the interest due on the loan is not being paid. The unpaid interest would then be added to the loan amount, increasing the debt. (Also, if the monthly payment rises the maximum 7.5 percent but the interest rate quickly increases, it is again possible to have a situation where there is negative interest and a rising loan balance.)

• With an "interest only" payment. This choice allows the borrower to make very low minimum monthly payments -- however, if you only pay interest you are not reducing the loan balance.

Caution. You must always make the minimum payment. Speak with your loan officer for details.

There is a one-year prepayment penalty on the loan. This means the program is not good for anyone who plans on selling his or her home in 12 months. Then again, buying a home for such a short term is generally not recommended, regardless of the financing.

Now let's talk about the LIBOR index.

Currently at 1.87 percent, there's no guarantee that it will stay there. In fact, over the last ten years, the LIBOR index has averaged 4.87 percent. But the statistics also show that the LIBOR index has only increased once by more than one percent in a year's time. That was in 1994.

However, in fairness, index rates can rise and fall. No one knows that the future may bring, so there is risk with an ARM -- any ARM -- that future payments can rise.

Historically, though, the LIBOR index pretty much follows the direction of short-term U.S. rates, such as the federal funds rate.

Here's why I think this LIBOR ARM is a good deal.

First, the fully indexed rate is phenomenal -- 4.11 percent. Second, the up-front costs are low -- no points. Third, the ten-year history of the LIBOR has averaged 4.87 percent and adding a 2.25 margin would make the rate 7.12 percent. Even that's not bad. Fourth, I believe short-term interest rates are poised to stay low.

So for whom might this loan be good?

• Any homeowner or potential purchaser seeking to minimize his monthly payment. Consider the following: The monthly principal and interest (P&I) payment on a $200,000, 30-year loan at 7 percent is $1,330. At 2.95 percent, the current minimum payment on the LIBOR ARM is $838 -- a difference of $492 per month and no negative amortization. In fact, in this example, the LIBOR ARM minimum payment would pay down $2,179 more in principal in the first year than the 7 percent rate (assuming the LIBOR doesn't change).

• Current homeowners who are seeking to lower their interest rate and monthly cash flow.

• A homeowner who wants to take advantage of the equity in his house. This is a good refinance program for those who want to consolidate consumer debt such as credit cards.

So there you have it. Remember, however, that there are many variations of monthly ARMs. If you like this kind of program, make sure you find one without points or a lengthy prepayment penalty. As I said, it's a complicated program -- make sure you understand it. And be aware that rates can rise.

For more articles by Henry Savage, please press here.

Published: January 16, 2002

Use of this article without permission is a violation of federal copyright laws.

, the president of PMC Mortgage Corporation in Alexandria, VA, is a mortgage columnist whose work has appeared in numerous consumer, real estate, and mortgage publications. Mr. Savage welcomes your questions for possible use in this column, however because of the volume of mail received, Mr. Savage cannot answer questions individually.