Before you wrap an ARM around your mortgage, think twice about home financing pitches that are coming on the heels of rising interest rates.

Right now, an ARM's interest rate will give you a mortgage that, on the average, will cost you about $400 a month less on a $250,000 mortgage than a fixed rate mortgage's (FRM) interest rate -- at first.

ARMs -- adjustable rate mortgages -- are called adjustable rate mortgages because that's what they do -- adjust. And, because their rates begin so low, eventually their rates move up more often than down.

Sooner or later the monthly savings you initially enjoyed could shrink, disappear and possibly bloat your monthly mortgage payment at a time you can least afford it.

"Adjustable rate mortgages have always made more sense than a fixed interest loan, but now they're making even more sense and becoming even more attractive, since fixed-interest loans have become more expensive with the sudden, dramatic rise in long term interest rates," said Anthony Cutaia, in a press release the "mortgage expert," radio talk show host and owner of the Boca Raton-based Cutaia Mortgage Group fired off on the PRNewswire service Aug. 14.

And California is fiscally fit.

"I would never assume that an ARM is better for one of my clients based on the interest rate alone. There are many factors that go into determining the best program for anyone," said Lyn Adams, a mortgage consultant with Certified Mortgage Specialists in Brookfield, WI.

Interest rates for fixed-rate 30-year mortgages for conforming loans have risen from a record low of 5.21 percent on June 12 and 19 to 6.34 percent on Aug. 7, before falling back to 6.24 percent Aug. 14, according to Freddie Mac's Primary Mortgage Market Survey. Meanwhile, 1-year ARMs have risen less, from 3.54 percent to 3.80 percent, before falling back to 3.75 percent.

The $250,000 mortgage with the fixed rate would cost you $1,537 a month while the ARM would lower it to only $1,157 -- at first.

ARMs are most often based on indexes tied to Treasury Bills that are issued by the U.S. government to pay for the national debt and other expenses. Most 1-Year ARMs are tied to the "Constant Maturity Treasury (CMT)" index which is based on the 1-Year Treasury Bill's activity. Other ARM indexes are based on certificates of deposit (CDs) and the London Inter-Bank Offer Rate (LIBOR) rates, among others.

To come up with the initial ARM rate, the lender will add a "margin", usually two to four percentage points, to the index.

An ARM's initial rate typically is lower than the fixed rate from about a quarter point to two points or more, depending upon the economy. Right now, almost two and a half percentage points separate them.

When the first adjustment occurs (typically from six months to one, three, five, seven and 10 years) and how often the rate adjusts, depends upon the terms of the loan. After the first adjustment occurs, subsequent adjustments typically occur every six months or once a year. The adjustment period is disclosed in the loan.

ARMs also generally have a limit or "cap" on how high it can adjust during each adjustment period as well as how high it can adjust over the life of the loan. The caps protect you from drastic market changes, but ARMS do not offer the locked-in interest rate stability of a fixed rate loan.

"ARMs do not make sense for all borrowers. They make sense for those borrowers who do not plan to stay in the homes over a long period of time, who have a stable source of income, and whose income is such that future rate increases would not produce 'payment shocks' that might threaten their ability to keep the homes," said Bruce Foote, a housing analyst with the Washington, D.C.-based Library of Congress.

"The Mortgage Bankers Association's National Delinquency Survey consistently shows that delinquencies and foreclosures are higher for ARMs than for fixed rate mortgages. This holds true for all states and all regions," Foote said.

An ARM's lower initial rate, can help you qualify for a larger loan or start you off with smaller payments than you'd have to pay for the same mortgage with a higher fixed rate. Lenders often will qualify you based on the first adjusted rate because it likely will be your average rate paid over the loan's term.

ARMs could be a good choice for someone who knows his or her income will rise and at least keep pace with the loan rate's periodic adjustment. If you plan to move in a few years and are not concerned about the possibility of a higher rate, an ARM also could be a good choice.

"Most people move about every seven to eight years. So, the risk to them, assuming the payment and interest caps are decent, is small. But, don't forget the caveats," said Sam Gilstrap, an enrolled tax agent from San Jose, CA.

"My two cents worth on ARMs is influenced by clients who lost an arm and a leg back in the 1980s. I remember one older couple that had a disastrous problem. Both worked and were not well off, nor did they have substantial savings. Other clients came near losing the property when the payments went up to the point of creating severe financial hardship," said Gilstrap.

Along with length of ownership and income projections, there are other factors to consider before shaking hands with an ARM.

"How might their lifestyle change during that (initial rate) time? Do you plan on starting a family or building a new home? What payment can they support now with factoring in debt ratios? ARMs can be a good alternative to a fixed rate in some instances, but they are definitely not for everyone," said Adams.

Home owners on fixed incomes especially should keep ARMs at, well, arm's length.

"Interest rates that go up by 1.25 percent is a 20 percent increase in the interest rate and that corresponds to about a 15 percent increase in the payment. If interest rates go up 1.25 percent the typical consumer's income is not going to go up by 15 percent," said Richard Calhoun, a real estate broker and statistician with Creekside Realty in San Jose, CA.

Published: August 22, 2003

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Broderick Perkins parlayed a career in old-school journalism into a contemporary digital news service that really hits home. The award-winning consumer journalist, originally from Wilmington, DE, is founder, publisher and executive editor of the bootstrap DeadlineNews Group, a Silicon Valley-based editorial content and consulting service specializing in residential real estate, consumer news and related editorial consulting services. The DeadlineNews Group includes the website, DeadlineNews.com, offering real estate editorial content and consulting services, and its back shop, the Deadline Newsroom, an open house on news that really hits home. Perkins obtained his formal journalism education from University of Delaware and a journalism boot camp, the Institute of Journalism Education at the University of California-Berkeley. He went on to 20 years of service as a daily newspaper journalist at the Wilmington, DE News Journal and San Jose, CA Mercury News. Perkins covered housing on the San Jose Mercury News reporting team which earned a General News Reporting Pulitzer Prize in 1989 for coverage of the Loma Prieta earthquake. He has also produced real estate, consumer and small business content for the Wall Street Journal, Los Angeles Times, RealtyTimes.com, Nolo.com, Better Homes and Gardens, the National Association of Realtors, Homestore/Move and Intuit/Quicken among more than three dozen publications. In addition to managing the DeadlineNews Group, Perkins most recently served as chief editorial consultant for Nolo's Essential Guide To Buying Your First Home, Nolo, and writes real estate television scripts for RealtyTimes.com.