Interest rates can affect the type of mortgage you choose and dictate when it’s wise to make a change. Here are a few of the factors that can be affected by a swing in interest rates:
Choosing a mortgage
When interest rates are rising, a fixed-rate mortgage is usually a good choice, since it locks in the current rate and protects you from the higher rates to come. When rates are falling, an adjustable-rate mortgage (ARM) becomes more attractive, as its interest rate changes periodically (usually every one, three, or five years), allowing you to benefit from the new, lower rates.
You may want to choose an ARM even when rates are rising. This is because the interest rate on an ARM is substantially lower -- as much as two percentage points lower than that of a 30-year fixed-rate mortgage. That means you’ll pay less until mortgage rates have increased a full two percentage points. After that, you’ll pay more than a fixed rate.
There are also hybrid ARMs, which have a fixed rate for a certain time period -- typically three to 10 years -- and then become adjustable. (A 5/1 ARM, for example, has a fixed rate for five years, after which your interest rate is adjusted annually.) Hybrid ARMs may be the right choice for you if mortgage interest rates are likely to rise in the short-term but then flatten or fall. However, these long-term trends can be difficult to predict.
A change in the interest rate trend can make it worth your while to switch to a different type of mortgage. When rates are falling, you can save money by moving from a fixed-rate to an adjustable-rate mortgage, so you can benefit from the lower rates. If mortgage interest rates appear set for a sustained rise, switching from an ARM to a fixed-rate mortgage can lock in a lower rate and protect you from higher payments. However, you should make sure that any closing costs don’t offset the benefits of refinancing.
Fixing your rate
Some ARMs allow you to convert to a fixed-rate mortgage interest rate when interest rates threaten to rise significantly. This is a useful option, since it protects you from drastically higher payments with less paperwork and expense than conventional refinancing.
If mortgage interest rates are rising when you’re negotiating your mortgage, it can pay to "lock in" your promised rate and points while your mortgage is being processed for around 30 to 60 days. This ensures you get the interest rate you’ve been quoted, even if the going rate is higher by the time your mortgage closes. There may be a fee to you for this guarantee.
Many of these decisions depend on how long you plan to stay in your home. For example, if you expect to sell in the next three or four years, an adjustable-rate or hybrid mortgage can give you a lower rate than a fixed mortgage for as long as you plan to own your home. You’ll have sold before the interest rates become too high.
At the same time, taking advantage of changing mortgage interest rates can require you to act quickly. Mortgage rates can rise and fall abruptly -- as much as a full percentage point in a couple of months. Track these moves so you’ll be ready to make the choice that makes sense for you.