I've been an outspoken advocate of the LIBOR ARM for a long time now, touting the mortgage as one of the better deals available to the American consumer. Now I'm receiving e-mails from readers who are questioning whether or not taking out a LIBOR-based mortgage is still a good move. Let's do a little research.

But first, let's recap. LIBOR stands for London Interbank Offering Rate. Basically, the LIBOR is the rate that European banks charge each other for short-term loans. American lenders have been offering adjustable-rate loans based upon the LIBOR index for years. The rate of a LIBOR ARM is equal to the LIBOR index, plus a margin, usually around two percent.

When American short-term rates started to drop in 2001, the LIBOR followed. Then the 9/11 attacks came, and short-term rates really fell through the floor. Let's look at some numbers:

The one-month LIBOR peaked in December of 2000, at 6.82 percent -- the highest yield in nearly 10 years. Any homeowner holding a LIBOR loan with a two percent margin would have been paying 8.82 percent. Ouch.

The economy started showing signs of slowing down, inflation was contained, so Fed Chairman Alan Greenspan began easing the credit markets by lowering the federal funds rate (sort of the American equivalent of the LIBOR). U.S. banks parroted the Fed's actions by lowering their prime rate. In fact, the prime rate dropped from 9.50 percent in January of 2001 to 5.00 percent by December.

What happened to the LIBOR? During the same period, January to December of 2001, the one-month LIBOR index sunk from 6.46 percent to 1.87 percent -- a 71 percent drop. Add a two percent margin to 1.87 and you have a mortgage rate of 3.87 percent. Not bad.

Interest rates continued to fall slowly in 2002 and 2003. The prime rate dropped to a modern low of four percent and the LIBOR fell to a rock-bottom 1.10 percent. LIBOR mortgage holders were loving it.

But there's one thing true about interest rates: they're dynamic. Everyone knew that these rates were eventually going to rise again and it's starting to happen. The economy is picking up and Chairman Greenspan is responding by raising rates in hopes of striking a balance between healthy economic growth and subdued inflation. The prime rate is now at five percent and the monthly LIBOR is approaching 2.20 percent.

Okay, so far we can conclude that short-term rates are roughly one percent higher than the three-decade lows of 2003. Does this mean ARM holders should panic? Does this mean the folks who decided on the safe road by taking out fixed-rate loans should gloat? Let's look at some other data:

Fixed-rate mortgages were hovering around 8.50 percent in mid 2000, after Greenspan's rate hike rampage that took the prime rate from 7.75 percent to 9.50 percent in 12 months. A fully indexed LIBOR ARM was hovering at about the same rate. Obviously, no one was interested in ARMs at a time when adjustables and fixed rates carried the same (or higher) rate.

Let's fast forward one year. By mid-2001, a LIBOR-based ARM was hovering around 5.75 percent. Fixed-rate mortgages had dropped to about 7.25 percent. A year later, the rate on a LIBOR mortgage had dropped to about 3.75 percent while the fixed rates dropped to about 6.75 percent.

Let's fast forward to the present day. A monthly LIBOR ARM with a two percent margin is running about 4.125 percent. A 30-year fixed rate with no points can be found at around 5.75 percent.

Here's the bottom line: When choosing a mortgage, it's critical to choose one that is tailored to your specific situation. Risk averse folks who are buying for the long term should indeed take out a fixed rate. But there are many who plan on selling their home, and thus, disposing of their mortgage, in far less than 30 years. There are also those who like the financial benefits of a lower-rate ARM. True, the rate on an ARM can increase, perhaps to a level significantly higher than what may have been available as a fixed rate, but until that time comes, ARM holders will be paying a lower interest cost.

I still think the LIBOR ARM is a decent bargain -- but it's clearly not as good as it was. For the right person, the LIBOR is the right choice. It depends on the borrower's particular objectives.

For those who hold a LIBOR ARM, you can expect your rate to climb a bit further as long as it continues to follow U.S. short-term rates. Follow Chairman Greenspan's moves. I may be dead wrong, but it seems to me the Fed has indicated that its series of rate hikes will continue to be measured and slow. Most analysts are predicting that the Fed will make only a few more increases. If the LIBOR follows, expect it to hit perhaps five or 5.50 percent. My bet is that after a period of stagnation, short-term rates will start falling again.

Published: December 9, 2004

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, 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.