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Refinancing an adjustable-rate mortgage to a “safer” loan

It’s easy to see if refinancing will save you money if you have a fixed-rate mortgage. If mortgage rates are lower now than they were when you took out the loan, chances are a refinance will be a good deal.

But what if you currently have an adjustable-rate mortgage? These loans have a lower fixed rate period for the first several years, but they can adjust significantly after the fixed rate period is over. For this reason, many homeowners will consider refinancing these loans to fixed-rate mortgages, which offer predictable payments.

The benefit of refinancing an adjustable-rate mortgage, or ARM, is significantly harder to determine. You might be trading a low payment right now for a higher payment in the short term — but gaining the security of knowing your interest rate won’t increase dramatically in the future.

In this article, we’ll discuss how to decide the pros and cons to refinancing an adjustable-rate mortgage to a “safer” loan.

We’ll cover:

What makes a mortgage “safe”?

In the mortgage world, a predictable monthly payment is considered the safest option. The 30-year fixed-rate mortgage is generally used as the benchmark, allowing for a monthly payment that doesn’t change over time. As each year goes by, more and more principal is paid until the loan is paid off.

However, there are situations where a fixed-rate mortgage may not make sense, leading you to choose a loan such as an ARM or an interest-only mortgage to keep your payment low for a period of time.

Perhaps you were expecting a major promotion or raise when you were house shopping, and needed a lower payment. Or maybe you hadn’t sold your old home and needed the lower payment to qualify for the new mortgage.

We’ll discuss some of the riskier features that you may have agreed to, and what refinance considerations you’ll need to make.

How adjustable-rate mortgages can be risky

Although your loan officer won’t specifically call them unsafe, there are elements of some mortgage loans that make them a riskier bet than others. Here are some reasons why you might pay these types of loans off with a new mortgage sooner rather than later.

When fixed rates are on the rise, a loan officer may suggest an adjustable-rate mortgage as a way to temporarily save on your monthly payment for a specified period — usually three, five or seven years. After that, the interest rates changes to match market conditions.

These loans can be considered “unsafe” because of the risk that the rates will go up after that initial fixed rate period.

The adjustable portion of the interest rate is based on a particular index, with the most common being the LIBOR (London Interbank Offered Rate), and the COFI (Cost of Funds Index). A predetermined margin is added to the index rate to give your mortgage its interest rate.

Your mortgage will have limits on how much higher your interest rate can go. For example a 5/1 ARM with 2/2/6 adjustments means your rate could go up a maximum of 2% for the first adjustment after the initial fixed rate period of 5 years, and then can adjust 2% per year after that to a maximum increase of 6% over the life of the loan.

In a worst case scenario, your payment could go up 6% in rate from where it started — from 4% to 10%, for example. If you refinance an ARM loan into a “safer” fixed-rate mortgage, you are protecting yourself against a large future payment increase.

For example, if you have a 4% rate now on a 5/1 ARM with 2/2/6 adjustments, and a $200,000 loan amount, your payment could increase from $954.83 to $1,199.10, if the index and margin increase to the the maximum after your first five years are up. That’s an increase of $244.27 per month.

However, that hasn’t happened yet in this scenario. If current 30-year fixed rates are at 4.25%, then choosing to refinance to that type of mortgage means your payment would actually going up to $983.88 — an increase of $29.05 per month.

The big question: Do you take the increase in payment of $29.05 now, to protect yourself from a potential increase of $244.27 in a few years?  If you don’t think you’ll be selling the house within that time period, then the best plan would be to refinance the house sooner than later.

Other “unsafe” mortgage loan elements

Balloon mortgage

A balloon mortgage is a loan type that offers a lower rate for a set period of time, followed by a balloon payment that requires the entire balance be paid in full after the initial lower rate period. They are pretty rare these days, but if you have one, it’s always a good idea to replace one with a regular fixed rate mortgage, especially if you don’t have the resources to pay the entire loan balance.

Interest-only loans

You may have taken out an interest-only loan to keep your payment very low at the beginning of your loan. Interest only loans only require you pay the interest on a monthly basis for a set period of time — meaning you’re not paying any principal. The original balance of the loan doesn’t go down if you make the interest-only payments.

There are three factors to consider if you want to refinance your interest-only loan. The first is obviously how much your payment is going to increase with the new loan. The second thing to consider is that fact that you aren’t building any equity in your home. Equity is the difference between your homes value and the balance of your loan.

The final consideration has to do with what your worst case payment will be once the interest-only period is over. The remaining balance will be due based on the number of years left on your loan — so if you have a five year interest-only loan, after the five years is up, you’ll have a 25-year amortizing payment schedule.

To give you an idea of the longer term consequence of keeping the loan beyond the initial interest-only period, here’s an example. Let’s assume you have a $200,000 interest-only loan for five years on a 30-year loan at 5% with a payment of $833.33 per month.  If you pay only the interest payment during the five years, after the interest-only period is up, your new monthly remainder of the loan will be $1,169.18 — an increase of $335.85 per month.

Prepayment penalty

If you had some major credit issues to overcome such as a recent foreclosure or bankruptcy, it’s possible that you may have taken a non-prime or even a hard money loan that has a prepayment penalty included. This is a fee payable to the lender or private investor if you pay off the loan within a predetermined time period.

The rates on these types of mortgage can be very high, making it beneficial to pay the loan off even if you will be subject to the prepayment penalty. If you are in a position where you qualify for a regular refinance loan under conventional, FHA or VA guidelines to pay off one of these loans, you may find your breakeven will be sooner than you think given how much lower your monthly interest rate and payment will be.

Evaluating the costs and benefits of refinancing a risky loan

If your current payment is lower than what it will be after you refinance, it may be hard to rationalize refinancing. Here are a few questions to help you with that decision-making process.

How long do you plan to keep your home?

If you plan to keep your home for a long time, it usually makes sense to refinance a loan with unsafe features into a safer loan. Even if you’re thinking about moving soon, life can change, and your plans to move in three years could suddenly become five years if a new job opportunity pops up or falls through.

With any risky feature, the general rule is to have an exit strategy before the loan payments become more expensive. If you can afford the payment on a mortgage based on current rates, it makes sense to refinance sooner than later.

How do you handle financial risk?

If you are already losing sleep about how high your payment could go up based on the terms of the loan you have now, then you have a pretty low threshold for risk. This is not a bad thing — it just means that you are likely to experience more anxiety about the unknown, and given that a mortgage payment is likely your biggest monthly payment, a big increase could become a big burden very quickly.

Which way are current interest rates headed?

Interest rates rise and fall just like stocks, and sudden changes in the economy, inflation, world politics, or a number of other factors can cause fluctuations.  Although it’s impossible to predict exactly what rates will do, there are a number of weekly reports that can give you an idea of which direction rates are headed.

Freddie Mac’s Primary Mortgage Market Survey® provides a weekly accounting of rates with an overview of economic reports that affect rates. The report features a graph that shows you the direction 30 year, 15 year, and 5/1 ARM have been taking, making it a good resource for tracking mortgage rate information.

Final thoughts

While a low monthly payment is always a good thing when it comes to having a mortgage, the permanency of that low payment is even more important. Many borrowers who defaulted during the housing boom couldn’t afford the ARM resets on their mortgages, and ultimately defaulted.

New regulatory agencies, especially the Consumer Finance Protection Bureau, enforce strict guidelines about what types of loans give you the best ability to repay. Don’t ever feel pressured to take a loan with any features you aren’t comfortable with.

However, if you do end up with one of these loans to bridge some temporary financial gap, at least you know that you always have the option to refinance your loan into a safer mortgage in the future.

 

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