For a long time adjustable-rate mortgages (ARMs) have been described as more risky for consumers then standard-issue fixed-rate loans, but should borrower's stay away from ARMs in today's marketplace?

There certainly is little dispute that ARMs are, indeed, risky when compared with fixed-rate loans. The risk is that interest rates will rise and with them monthly mortgage payments. If rates rise enough, those who teeter on the edge of financial stability may well have insufficient funds to meet their housing bills -- not good news for either borrowers or lenders.

Some of the risk is contained, however. Most ARMs have built-in caps that limit monthly payment increases to 7.5 percent. If you pay $1,000 a month now, such a cap would limit your payment next year to $1,075.

Another form of cap is the lifetime interest limit, generally no more than 6 percent over the start rate for conventional ARM loans and 5 percent for FHA ARMs.

A third type of cap is the annual interest rate limit -- usually 2 percent for conventional ARMs and 1 percent for the FHA ARM product.

If you look at general interest trends in recent years ARMs have been -- even with the potential risk they represent -- a good bet. ARM start rates are typically below prevailing fixed-rate mortgages which means borrowers can qualify more easily for ARM financing. ARMs often feature more liberal qualification standards because lenders prefer such loans, which means folks can borrow more or get loans which otherwise might not be available. And, no less important, in recent years interest rates have generally sunk thereby reducing the threat of rapidly-rising mortgage payments -- just look at the rates for ARMs based on the LIBOR (London Interbank Offered Rate) rate, the 11th District Cost of Funds Index, and Treasury bills and securities.

All of this is very nice, but it gets us back to the original issue: ARMs are risky and with interest indexes at the lowest levels seen in decades such risk should not be discounted.

If you believe that interest levels will generally remain where they are or actually decline, then you may feel that the economy will stagnate or even deflate. In such an environment interest rates may drop to microscopic levels -- look at Japan since 1989 -- but the stock market will take a beating and getting a job will be tough.

Or, you might think that interest levels will rise. In such an environment, if you have a 1-year ARM with a 4.50 percent start rate and a 6 percent lifetime cap, then in a few years your monthly cost for a $100,000 loan could go from $312.63 for principal and interest to a maximum payment of roughly $914.74.

There is, of course, also risk with a fixed-rate loan. Borrow today at 6 percent and your interest level will stay there even if mortgage rates drop substantially.

So, yes, everywhere you turn there is risk. But those with fixed-rate mortgages need not worry about rising interest costs because they pay the same monthly amount for principal and interest during the life of the loan. And if rates drop enough, fixed-rate borrowers can refinance, as millions have done in the past few years.

So will rates rise? Every set of tea leaves produces a different reading and you can find economists, seers, and soothsayers who will support either side of the argument -- and sometimes both sides. But the important point is this: It logically follows that as rates decline month after month there has to come a point when we reach bottom. It then makes sense that rates will again rise -- a curiosity for those with fixed-rate loans but a potent concern for ARM borrowers with rates tied to the marketplace.

The economic trends we are seeing today seem new, fresh -- and troubling. The conservative view is that now might be a very good time to pay down debt, reduce monthly costs, and consider ARMs with some caution. Given where fixed-rate interest is today -- at low levels that were unimaginable just a year ago -- those steady monthly payments may well be a prudent choice for many borrowers.

For more articles by Peter G. Miller, please press here.

Published: October 8, 2002

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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 .