It sure looks tempting, doesn't it. A mortgage rate of 4.00%. You're just licking your chops over that one, aren't you? Think of all the money you'd save with a rate like that. Sure, it's an adjustable rate mortgage, but ARMs have been quite stable over the past few months so why not take the plunge? Because ARMs are going nowhere but up, that's why.

Adjustable Rate Mortgages, or ARMs, are mortgage rates tied to a particular index with a margin added for good measure to calculate your note rate. Common mortgage indices are the one year Treasury index or the LIBOR index, depending on which loan you choose. The margin is the amount, in percent, added to the index to calculate your rate. If your one year Treasury index stands at 2.45% at the time of your adjustment and your margin is 2.75% then your new note rate would adjust to 5.20% until time for your next adjustment.

Most adjustment periods are once every six months or once every 12 months. Still others adjust every other year, every third year, every month or pretty much any predetermined adjustment period you and your lender both agree upon. There are also consumer protection caps, called Rate Caps, that keep mortgage rates from swinging wildly from year to year. A typical rate cap on an annual basis is 2%, or 2% above or below the previous year's rate.

So why should you avoid an ARM? Not everyone should, in fact, ARMs can be an attractive loan program under the right circumstances, particularly for those who anticipate having a mortgage for a very short period of time, say less than three years. But if you're looking longer than that then you may want to forego an adjustable rate mortgage loan. Aren't many ARM programs at or near historic lows? Yes they are. And that's why you should forget about them

Most in the financial services industry will agree that interest rates are at their bottom and that Greenspan and his pals have stopped cutting interest rates. While Chairman Greenspan has little to do with a mortgage rates directly, rate moves are closely anticipated and markets will typically move in advance of most Fed action.

In other words, there is no where else for rates to go but up. One year ago the one year Treasury Index sat right at 6.13% while today that same index is at 2.38%, or a reduction of 3.75%. That's a significant drop in demand in just a 12-month period. During that same period, the Feds dropped the Federal Funds rate by only 2.25%. It's by this number that you can see that the Feds and your ARM index have little in common.

If indeed we have seen the last of these rate cuts for quite some time then what's next? Rate increases, naturally. When? That's a guess, but an educated one would say soon. That said, if you choose an ARM today, it's likely your rate will get back to 'normal' levels in a relatively short period. Even if you started today at 4.00% and hit your 2% cap next year your rate would then start at 6.00%. Still not bad, but if rates continued their historical path, you'd also hit 8.00% the following year, and higher still if the trend continued. Well above current fixed fare in the low to mid 6% range available today.

Those that are winning the ARM races now are those that opted for an adjustable rate mortgage a year or two ago. Those programs today are adjusting in the low 5's, and some adjusted in the high 3's just a few weeks ago. But that was then and this is now. Rates are on the upswing, and that's not the time to jump on the ARM bandwagon. Let that wagon leave the station.

Published: May 31, 2002

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, a veteran Mortgage Banker, successful Real Estate Consultant and author of Your Guide to VA Loans, Mortgages 101: Quick Answers to Over 250 Critical Questions About Your Home Loan, Who Says You Can't Buy a Home!, and Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You, is a former columnist and Contributing Editor with San Diego-based Mortgage Originator Magazine. Reed is President of CD Reed Mortgage Bankers, Austin, TX and is a Past President of the Austin Mortgage Bankers Association.