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Is It a Good Time for an ARM Refinance?

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You should refinance your adjustable-rate mortgage before it resets if the new payment will strain your budget, or you prefer the stability of a mortgage payment that doesn’t change. While an ARM loan offers the benefit of a lower rate for a set time period, the rate can fluctuate after the fixed-rate period expires.

Understanding how an  ARM refinance works may help you answer the question: Should I refinance my ARM before it resets?

When an ARM refinance makes sense

It’s typically worth it to consider refinancing if you can switch to a fixed-rate mortgage, save money on your monthly payment and recoup your closing costs within a reasonable time. You can calculate your refinance breakeven 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.

However, there are other reasons to refinance an ARM mortgage.

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 your “fully-indexed rate,” which is the adjusting rate you’ll pay over the life of your ARM loan. If the payment at that fully-indexed rate makes you lose sleep, an ARM refinance may be worth it.

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 income.

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. You can apply the monthly savings to build a down-payment fund for a new home or make extra payments on your loan balance to build equity faster.

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 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.

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.

Initial interest rate. This is the temporary low fixed rate you’ll pay for a set time, typically one, three, five or seven years. For example, you’ll pay the initial rate on a five-year ARM for the first five years.

Adjustment period. This is the second number associated with your ARM . It reflects how often your rate could change after your initial rate period ends. For example the “1” in a 5/1 ARM represents one year: After five years, your interest could change every year for the rest of the loan term.

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.

First 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.

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 3% on a 5/1 ARM with 2/2/6 adjustment caps.

Initial rate  3%
Rate after first adjustment cap (2%) 5%
Rate after subsequent adjustment caps (2%) 7%
Lifetime adjustment cap (6%) 9%

THINGS YOU SHOULD KNOW

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.

FAQs about refinancing an ARM mortgage

Why is an adjustable rate mortgage bad? ARM loans may be a “bad” choice if you don’t understand how they work or have a good reason for using one. They are best if you need short-term savings and have a plan for an ARM refinance or selling your home before the initial rate period expires.

Which is better, a fixed rate or an ARM? A 30-year fixed-rate mortgage is often better for borrowers who prefer the stability of a predictable mortgage payment and plan to stay in their home a long time. An ARM may be better for borrowers who need the lowest payment possible for a short term, but have the financial resources to cover the fully-indexed rate payment or plan to live in their home for a short time.

What are current ARM mortgage rates? Try a comparison rate site to shop the ARM loan estimates from at least three to five lenders. Pay close attention to the initial adjustment caps — some programs have initial adjustment caps as high as 5%, which could make your mortgage unaffordable if the overall indexes are on the rise.

Does refinancing my ARM reset my loan term? If you choose a new loan with a 30-year amortization, you’ll restart the loan clock at 30 years. Most ARM loan products are tied to a 30-year amortization schedule. However, you could choose fixed-rate loan terms as short as 10 years, as long as you can afford the higher payment that comes with a shorter term.

What if I have a prepayment penalty? Prepayment penalties are rare these days, but check with your lender to confirm you don’t have one before you start the refinance process.

Could my ARM rate go down? Yes. If the Federal Reserve has been cutting rates since you took out your ARM loan, you could end up with a lower rate when your ARM adjusts. There have been several examples in recent history of ARM rates actually dropping below fixed rates.

Could my ARM change more than once per year?  Yes. Some ARM programs adjust every six months, which means after your fixed-rate period ends, your rate could go up or down every six months. Make sure you understand all the terms of your ARM loan detailed in the closing disclosure you receive three business days before closing.

 

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