ARMs can be more complicated

There's a lot to think about when refinancing an ARM. Should you refinance to a fixed rate mortgage (FRM) or to another adjustable rate mortgage? Those who get it right can save themselves serious amounts of money. However, it's also possible to lose big, so it's important to understand the factors that make ARMs good and bad risks, and then consider them as they relate to your personal circumstances.

Hybrid ARMs

ARMs come with interest rates that do not remain constant throughout the life of the mortgage – rates can adjust up or down according to the terms of the loan, which are specified in the mortgage disclosures. Nearly all ARMs today are "hybrids", meaning they start off as fixed-rate loans for an agreed introductory period, and only when that expires do they beginning resetting at predetermined intervals. At every rate reset, a published index is checked (for example, the one-year Treasury or six-month LIBOR), and the new rate is calculated based on that value. LIBOR ARM rates, for example, are based on the London Interbank Offered Rate, or LIBOR.

The shorthand descriptions of ARMs are easy to understand. Each is expressed as an"X/Y" ARM, with x being the years until the first rate reset and Y the years between subsequent resets. So a 5/1 ARM is fixed for five years and then can reset every year thereafter.

Hybrid ARM reset according to caps and floors which limit how much the rate can change at any one reset and how high or low the rate can go during the life of the loan. Caps are important because they reduce the borrower's risk, while floors decrease the risk to the lender.

What's the Attraction?

There's really only one reason why you would opt out of the security and certainty of a fixed-rate mortgage (FRM) to go for an adjustable-rate one, and that's because ARMs come with much more attractive introductory interest rates. Generally, the shorter the initial fixed period, the lower the rate. On December 26, 2014, for example, LoanExplorer by LendingTree listed the introductory rate for a 3/1 ARM at 2.5 percent, a 5/1 rate at 2.625 percent, and a 7/1 rate at 3.0 percent. Meanwhile, the 30-year fixed rate for that date was 3.75 percent. Here's how the savings stack up if you were to keep a $300,000 home loan for three, five or seven years and chose one of these ARMs instead of a fixed loan:

  • 3/1 over three years: $4,483
  • 5/1 over five years: $11,064
  • 7/1 over seven years: $17,135

Calculating the Risk

The key to understanding ARM risk is the word "introductory." The potential savings may be significant to start with, but the risk when the introductory rate expires may be considerable. Just about all experts expect rates in general to rise over the next several years, and very few believe that rates can be reliably predicted over the long term. This may be why ARMs are much less popular than they once were.

However, there is a group for whom adjustable-rate mortgages make lot of sense: those who don't expect to keep their homes or their mortgages for many years. According to the U.S. Census Bureau, that's quite a big group. In 2012/13, nearly 36 million Americans (11.69 percent of the population) moved. The average home buyer in the US keeps the property about seven years, with younger and first-time buyers tending to sell up sooner, and older, more established homeowners remaining longer.

This means many homeowners are paying a premium for the security of 30- or 15-year FRMs when they don't need it.

ARMed and Dangerous -- or Not

And that's where ARMs make sense. If you anticipate moving in less than eight years or so, choosing a 3/1, 5/1 or 7/1 ARM could save you quite a lot of money. Even if your tenure in the home should exceed your expectations, you may still come out ahead, because of three factors:

  • Interest rates might not be much higher (or at all higher) when the loan resets.
  • Your loan's caps could keep your payment and rate from increasing to unaffordable levels during the first few resets.
  • You may be able to refinance to another hybrid ARM with a new low rate at the end of your introductory period.

All this means refinancing an ARM requires a risk/benefit analysis: what you stand to gain if your plans go as expected, and what could be lost if they don't -- together with a realistic assessment of the probabilities involved. ARMs are riskier than FRMs, but those who are clever (or lucky) enough to play the odds correctly can be handsomely rewarded.