ARM Refinance: When and How

Adjustable-rate mortgages (ARMs) have fallen out of favor in recent years, but is that a reason to refinance out of an existing ARM? There are some specific events that could trigger an ARM refinance.

Certainly, ARMs are less popular than they once were. As of late 2014, ARMs represented less than seven percent of mortgage application activity, according to the Mortgage Banker's Association. If you have an ARM, should you take this as your cue to refinance? Possibly, but don't rule out the notion of refinancing into a new ARM.

ARM Refinance: Triggering Events

Since ARM rates adjust automatically to changing market conditions, they eliminate much of the need to refinance that comes up with fixed-rate mortgages. However, two prominent reasons to refinance an ARM are as follows:

  1. You feel mortgage rates are poised to rise. Note that ARM rates may still have an advantage over fixed rates even after rates have fallen, so you might not want to refinance your ARM just because rates have fallen. After all, they might simply stay low for a period of years. However, if you believe that rates are likely to rise for reasons of economic strength, inflation, or changes in monetary policy, you would be wise to get out of your ARM while you can still lock in a low rate.
  2. Your planned repayment time has lengthened. The risk of rising rates in an ARM increases over time, so an ARM can be a great fit for anyone who plans to pay off a mortgage in a few years, either due to a cash windfall or because they expect to sell up and move. However, if your plans change and now you are looking at repaying the mortgage over more than just a few years, you may want to rethink your ARM.

With all potential refinancing decisions, be sure to take into account any prepayment penalty you will face on your current mortgage.

ARM Refinance: 4 Key Questions

If circumstances prompt you to consider refinancing your ARM, there are four questions that will help guide you through the process of deciding whether to go through with refinancing, and what type of mortgage your new loan should be:

  1. How much could my rate change now? ARMs have caps that limit the amount the interest rate can rise at each adjustment and also over the life of the loan. If your planned repayment period has lengthened, run some numbers on a mortgage calculator showing what could happen to your interest rate - and your payments as a result - if rates rose over the remainder of your prepayment period. This will give you a feel for the risk you are taking by staying in an ARM.
  2. Could a new ARM buy me some time? If you are concerned about rising rates but still expect to repay your mortgage in five to 10 years, switching from one ARM to another could allow you to buy some time while still taking advantage of lower current ARM rates. For example, suppose you originally signed up for a 5/1 ARM, meaning that the initial rate is set for five years, and then changes every year thereafter. Now, you find you still have a few years left before you can pay off the mortgage. Refinancing to a fresh 5/1 ARM would allow you to lock in a rate for another five years, but at a rate lower than a fixed mortgage rate.
  3. Am I comfortable locking in at today's mortgage rates? This is a tough decision when rates are high, because while a fixed rate mortgage will give you stability, you may miss out on potential rate drops. However, when rates are already low, there is less potential for them to fall further, so people are typically more comfortable locking into a fixed rate mortgage.
  4. What repayment period works for me? Generally, the shorter the repayment period, the less interest you will pay, so the big factor in deciding your repayment period is how big a monthly payment you can afford. If you can afford a fairly short repayment period, you might consider refinancing into a fresh ARM. If an intermediate repayment period seems called for, a 15-year fixed rate loan might be the best fit, while if you have to stretch out payments as much as possible to make them fit your budget, a 30-year fixed-rate mortgage is indicated.

The most prominent feature of ARMs is their rate flexibility, but with mortgage rates so low, many consumers have concluded that flexibility is more of a potential curse than a blessing. Working through the above four questions will help you decide whether the same conclusion should apply to your situation.

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