Is It a Good Time for an ARM Refinance?
If your adjustable-rate mortgage (ARM) hasn’t undergone a rate adjustment yet, it will after the fixed-rate period expires. And if the new payments are likely to put a strain on your budget, or if you just prefer the stability of a mortgage payment that doesn’t change, you may want to refinance your ARM loan.
Understanding how an ARM refinance works may help you figure out if now is a good time to refinance your ARM loan.
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When an ARM refinance makes sense
It’s typically worth it to refinance an adjustable-rate mortgage (ARM) if you can save money on your monthly payment and recoup your closing costs within a reasonable time frame. Or, if you’re looking to stabilize your monthly payments, it can make sense because it allows you to switch to a fixed-rate loan.
You can calculate your refinance break-even point by dividing your savings by the closing costs — if you plan to stay in the home for the number of months it takes to recover your costs, the refinance probably makes sense. LendingTree’s refinance calculator makes it easy to skip the math and get straight to the point.
Refinancing an ARM loan into a fixed-rate loan
There are several great reasons to refinance an ARM mortgage into a fixed-rate loan.
To prevent a future increase in your house payment
When you took out your ARM loan, you were given a consumer handbook on adjustable-rate mortgages (CHARM) with details about how your “fully-indexed rate” can differ from the lower, “teaser” rate you might pay at the beginning. If the dollar amount you’d be paying at that fully-indexed rate makes you lose sleep, it might make sense to refinance the ARM loan into a fixed-rate loan.
To budget for an income change
If retirement is around the corner or you’re changing jobs and taking a lower salary, refinancing your ARM to a fixed-rate mortgage will help remove uncertainty about your house payment as you adjust to life with a lower or fixed income.
To pay off an interest-only ARM loan
Some ARM programs offer an interest-only option, allowing you to pay just the interest due each month. The drawback is you don’t build any home equity because you don’t pay off any principal. If you refinance your interest-only ARM to a regular fixed-rate mortgage with a PITI payment (principal, interest and taxes and insurance) you’ll avoid a dramatic rise in your payment after the interest-only period ends.
To tap your home equity with a cash-out refinance
A cash-out refinance loan offers you the ability to replace your current ARM with a fixed-rate loan, while also receiving a large lump sum of cash.
Refinancing an ARM loan into a new ARM loan
But what if you don’t want to get into a fixed-rate loan — can a refinance still make sense? Here are a few cases where a refinance into a new ARM could suit your financial goals.
To get a lower ARM interest rate.
If you plan to own your home for a short time and ARM rates today are lower than what you’re paying, refinancing to a new ARM loan may make sense.
To tap your home equity with a cash-out refinance.
If you want access to a large amount of cash, you can refinance into a new ARM loan and pocket the cash you need at the same time. You’ll also enter a brand new fixed-rate initial period, meaning three to 10 years (depending on your loan) of low monthly payments now and, potentially, downward adjustments in your interest rate if the market shifts downward after that.
How does an ARM loan work?
ARM loans have a lot of moving parts. Contrary to popular belief, your mortgage payment does not always go up when your ARM adjusts. In fact, when the federal funds rate is very low, your monthly payment may actually fall. To determine how much your interest rate could rise or fall, you need to understand ARM terminology.
- Margin. The margin is the fixed part of your ARM rate set by the lender. It’s added to the index to determine what your total rate will be once your initial fixed-rate period passes. The sum of your index plus your rate is called the fully-indexed rate.
- Index. The index is the moving part of your ARM loan, and it’s tied to a benchmark rate such as the Constant Maturity Treasury (CMT). The index often fluctuates with economic data and financial markets.
- Adjustment caps. These give you a worst-case look at how much your rate could rise if the margin and index are on the rise when your initial fixed rate expires. When you took out your ARM loan, your closing disclosure form listed adjustment caps, which provide details about your first adjustment, subsequent adjustment and lifetime adjustment caps.
- Initial adjustment cap. This sets the limits for how much your rate can go up once your fixed rate rises after your initial fixed-rate period. For example, if you have a 5/1 ARM with 2/2/6 caps, the first “2” means your rate could rise by a maximum of 2% after five years.
- Periodic (aka “subsequent”) adjustment cap. Each year after your first adjustment cap, your rate can change based on the term of your arm. In our example above, the “1” in the 5/1 ARM means your rate will change every year for the remainder of the loan’s life. Using the same 2/2/6 caps, the second “2” reflects how much your rate could rise after the second year, and every other year subsequent that.
- Lifetime adjustment cap. This number reflects the maximum your rate could go up over the life of the loan. A 5/1 ARM with 2/2/6 caps can rise a maximum of 6% from the rate you start.
Here’s an example of the maximum your rate could go up, assuming an initial rate of 5.39% on a 5/1 ARM with 2/2/6 adjustment caps.
|Rate after first adjustment cap (2%)||7.39%|
|Rate after subsequent adjustment caps (2%)||9.39%|
|Lifetime adjustment cap (6%)||11.39%|
If you’re worried about your interest rate changing in the future but need the flexibility of a lower initial rate, ask your lender whether they offer an ARM loan with a conversion option. This allows you to “convert” your loan to a fixed rate in the future without having to refinance. There may be a fee to use the conversion option, so make sure you understand how any conversion clause works and how much it costs.
ARM refinance requirements
ARM refinance requirements should look very familiar — they’re the same refinance requirements you’d see for a fixed-rate refinance.
- Credit score. Conventional loan requirements set 620 as the minimum credit score needed to qualify for a loan. If you have a score between 500 and 619, you may want to look into an FHA loan.
- Equity. You’ll typically need at least a little bit of home equity to use a refinance loan (2.25% to 3% depending on the loan type). However, if you can qualify for a VA loan or an FHA streamline refinance, there’s no minimum amount of equity you’ll need because you can get a VA mortgage without any down payment.
- Debt-to-income ratio (DTI). A DTI of 35% or less is generally considered “good,” but you can qualify for most conventional refinance loans with a DTI ratio of up to 50%. FHA rate-and-term refinance loans top out at 43%, while FHA Streamline Refinance loans don’t set a hard cap.
- Time since the original loan closed. How long you’ll have to wait to refinance varies based on your loan program and what type of refinance you’re seeking. Rate-and-term refinances tend to have less stringent waiting requirements than streamline or cash-out refinances.