Should You Refinance Your ARM Before It Resets?
If you’re losing sleep because you received a notice that your adjustable-rate-mortgage (ARM) is about to change, it might be time to consider refinancing your ARM to a fixed rate. While ARMs offer you the benefit of a lower rate for a set time period, their rates can fluctuate after your fixed rate lock expires.
Whether you’re thinking about a 5/1 ARM refinance or plan to switch to a fixed-rate mortgage, we’ll discuss why you might consider refinancing your ARM when it’s about to reset.
In this article, we’ll cover:
- When to refinance your ARM
- Should I refinance my ARM to a fixed-rate mortgage?
- Should I refinance my ARM to another ARM?
- Understanding ARM adjustments
- What your ARM adjustment caps mean
- FAQs about refinancing an ARM before it resets
When to refinance your ARM
You should refinance your ARM loan if you’re nearing the end of your initial fixed-rate period, and current mortgage rates are close to or better than what you’re already paying. If you’re not sure when your ARM is due to adjust, don’t worry — your lender is required to give you at least a 60- to 120-day advance notice of any interest rate changes on your ARM.
There are several other reasons to refinance an ARM:
To prevent an increase in your house payment. ARM rates can rise after the initial fixed period, which can drive up your monthly mortgage payments. If you don’t have extra wiggle room in your budget, affording those higher payments might be a challenge — and that could put you behind on your mortgage payments. A 30-year, fixed-rate mortgage provides a steady monthly payment.
To budget for an income change. If retirement is in your near future and you’ll be living on a lower, fixed income, or if you’re changing jobs and taking a lower salary, you should refinance your ARM to a fixed-rate mortgage. Even if you’re saving only a marginal amount every month, you’ll have peace of mind knowing the payment won’t go up if your ARM interest rate rises.
To get a lower ARM interest rate. If you have shorter term plans to own your home and ARM rates are lower than what you currently have, refinancing to a new ARM loan can make sense. You can use the savings to build a down payment fund for a new home in the future, or apply the savings to pay your mortgage off faster. Make sure you shop your mortgage refinance across multiple lenders to get the best ARM refinance rates.
To pay off an interest-only ARM. Some ARMs allow you to make interest-only payments for a set time period. This can result in a very low payment, because you pay only the interest due, with no principal payments applied toward the loan balance.
This can be dangerous in the long term, because after the interest-only period expires, the payments could rise dramatically if the principal isn’t paid down at all. The example below shows how an interest-only 5/1 ARM of $211,000 with a start rate of 4% could adjust after the interest-only period ends — the principal and interest payment more than doubles in a worst-case scenario.
|Payment years 1 to 5||Payment years 6 to 8||Payment years 9 to 11||Payment years 12 to 30|
Should I refinance my ARM to a fixed-rate mortgage?
If rates don’t increase, or if they increase slowly, refinancing may simply leave you with a more expensive loan with a higher monthly payment. When you refinance an adjustable-rate mortgage to fixed-rate loan such as a fixed-rate mortgage, there’s a good chance that your monthly payment will increase, at least in the short term.
Below is a payment comparison for refinancing a $200,000 ARM into a new loan that is a half-percent lower or higher than a starting rate of 3.5%. The last two columns show the changes you might be subject to after the fixed-rate period on a 5/1 ARM with 2/2/6 adjustments has expired.
|Current ARM start rate||Rate .5% lower||Rate .5% higher||First adjustment max||Max adjustment|
Here are additional considerations to help you decide if you should refinance your ARM:
Rates have dropped considerably. This is a no-brainer. Make sure you divide the refinancing costs by the savings to determine your break-even point. As long as you stay in your home for as long as it takes to recoup the refinance fees, refinancing makes sense.
Rates are higher, but adjustment maximums will push up your payments dramatically. You need to look at your first adjustment maximum as well as the lifetime adjustment maximum to determine how much your payments could go up without refinancing the ARM.
For example, it may make more financial sense to refinance into a fixed-rate mortgage with a monthly payment that’s $56.74 higher than what you currently have to avoid a future payment that could rise by $237.49 per month after the first ARM adjustment, or by $783.62 per month over the life of the loan. If your monthly budget can’t take a $200 or more increase and you plan to stay in your home for several years, then paying an extra $56.74 may be more manageable in the long run.
You have a convertible ARM. A convertible ARM usually comes with a slightly higher interest rate during the fixed-rate period, but it gives you the option to switch to the current fixed rates without going through the full refinance process. Sometimes, there’s a fee for exercising your conversion option, but it will save you on the closing costs of a regular refinance.
Should I refinance my ARM to another ARM?
When fixed rates drop, so do ARM rates. This is especially true when the Federal Reserve lowers rates, since the adjustable portion of your payment is often tied to the same forces that move the Fed funds rates.
You could choose a shorter initial fixed-rate period, such as a 3/1 ARM instead of a 5/1 ARM refinance, if you only want to stay in the house for a few more years. Just be sure to calculate your break-even point to make sure you can recoup closing costs before you sell the home.
Breakeven calculations are easy to make — just divide your total closing costs by your savings to get the number of months it will take to recoup your costs. For example, if you are saving $100 per month by refinancing to a 3/1 ARM and your closing costs are $2,400, then $2,400 divided by $100 equals 24 months. If you plan to stay in the house for three years (36 months), then you’ll recoup the costs before you leave and refinancing makes financial sense.
Understanding ARM adjustments
ARMs can be somewhat complex. Before making the decision to refinance your ARM, it’s important to understand the moving parts of an adjustable-rate mortgage — specifically the index and margin, and the adjustment caps. While most people worry about whether an ARM payment will go up, borrowers can benefit when rates fall.
How the margin works: The margin is the fixed part of your payment. It’s added to the index to determine how much your rate will adjust once your initial fixed-rate period has passed.
How the index works: The index is the moving part of your loan. It’s tied to a benchmark rate such as the District Cost of Funds Index (COFI) or the Constant Maturity Treasury (CMT), and fluctuates with economic data and financial markets.
When you took out your ARM, your closing disclosure form listed the initial adjustment cap, subsequent adjustment cap and lifetime adjustment cap.
What your ARM adjustment caps mean
Let’s say you have a 5/1 ARM with 2/2/6 caps. The table below explains what each number represents.
|The first “2”:
First adjustment cap
|The second “2”:
Subsequent adjustment cap
|This sets the limits for how much your rate can go up after your fixed-rate period ends.||The maximum percentage your rate can go up each year after your first payment adjustment.||The maximum your rate can ever go up above your initial fixed rate.||This is the “moving” part of your ARM and is added to your margin.|
|What it means:||What it means:||What it means:||What it means:|
|Your rate could increase 2% above your start rate after your fixed rate period expires.||Your rate can go up a maximum of 2% every year after your initial payment adjustment.||You payment can’t rise more than 6% from the initial rate you received during the fixed-rate period.||If the index goes up, your rate goes up. If the index goes down, your rate drops.|
FAQs about refinancing an ARM before it resets
How do I refinance an ARM?
There’s no difference in the refinance process for an ARM or a fixed rate. In most cases you’ll need income, assets and credit verification, as well as a new home appraisal to verify the value of your home.
Does refinancing an ARM reset my loan term?
Yes. If you choose a new 30-year fixed loan, or an ARM tied to a 30-year fixed term, you restart the clock on your mortgage, meaning you’ll likely pay more in interest over the long run.
What if I have a prepayment penalty?
Prepayment penalties are rare these days, but it’s worth checking with your lender to confirm you don’t have one before you start the refinance process.
Could my ARM rate go down?
If the Federal Reserve is cutting rates, 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.
How much can my ARM payment go up?
Make sure you have a copy of the closing disclosure you signed when you closed the loan. It outlines exactly how much your payments can increase in a worst-case scenario.
What happens when an ARM resets?
Your rate could go up, stay the same or go down. It all depends on the terms of your current ARM, mortgage rate movements, the economy and financial markets.
Could my ARM reset more than once per year?
Yes. Some ARMs come with six-month adjustment periods, which means that once your fixed-rate period is up, your interest rate and payments could change every six months. All of these details should be clearly stated in your closing disclosure.