Welcome to our week-long series on refinancing your mortgage. In this last of five articles, we look at when and how you should refinance from an adjustable rate mortgage into a fixed rate loan.
Adjustable rate mortgages are a two-edged sword. You get an initial mortgage rate lower than what you’d find on a fixed rate loan. But the rate adjusts periodically, raising the possibility that the interest rate on your mortgage could go up substantially, raising your monthly payment.
So today we are going to cover when and how you should refinance an ARM into a fixed rate loan. Let’s start with a quick recap of these two types of home loans.
Fixed Rate vs. ARMs
A fixed rate mortgage has a fixed interest rate for the entire term of the loan. My wife and I just refinance into a 30-year fixed rate mortgage at 3.875%. Over the entire 30-year term of the loan, the interest rate will never change. That means that the principal and interest payment will never change either. The only thing that could increase are monthly payment is if taxes or insurance goes up.
The benefit to a fixed rate loan is certainty. We can plan our monthly budget with confidence that are largest payment will never rise due to increasing interest rates. And that’s true even if market rates were to skyrocket. Currently, for a person with a good credit score, 30-year fixed rates are less than four percent.
On the other hand, the interest rate on an ARM varies according to a specific benchmark. The initial interest rate is normally fixed for a period of time after which it is reset periodically, typically once every one to three years. The interest rate paid by the borrower will be based on a benchmark plus an additional spread, called an ARM margin.
ARMs come in different types. A 5/1 ARM has a fixed interest for the initial five years. Then, the interest rate for this mortgage keeps adjusting every year until the mortgage is paid in full. A few ARMs have a fixed interest rate for as little as one year or as long as ten years. Some ARMs adjust twice in a year, but these are rare. The most common ones are the 5/1 ARM and the 3/1 ARM. Depending on market conditions (the shape of the yield curve), an ARM might have a large initial payment advantage over a fixed-rate mortgage. However, there is a probability that the payments on the ARM will rise over time.
For my real estate investments, we typically get a 5/5 ARM. The interest rate is fixed for five years, and then it resets for another five years. These mortgages typically have a 15-year term.
Are Adjustable Rate Mortgages Ever a Smart Move?
While ARMs have gotten a bad reputation during the market downturn, there are some good reasons to get an ARM. If you know for certain that you’ll sell your home in five years regardless of the market, a 5/1 ARM is a perfectly reasonable choice.
In some cases, homeowners take out ARM’s with the intent of refinancing before the rates adjust. While this strategy can work, it comes with significant risk. You could find yourself unable to refinance due to poor credit, loss of a job, or a falling market. The result could be that you get stuck with an ARM at a time when rates are on the rise.
For this reason, I believe that 99% of the time, a fixed-rate loan is best.
Refinancing an ARM–Factors to Consider
So if you have an ARM and are thinking about refinancing, what should you consider?
First, how long will you be in your home? This question is critical to the analysis, particularly given the low rates today. If my ARM was going to adjust this year, I wouldn’t be too concerned with interest rates. On a 5/1 or 3/1 ARM, the interest rate could very well go down if it resets this year. If your plan is to move before the loan resets a second time, sticking with the ARM may be a reasonable decision.
On the other hand, if you plan to stay in the home for years to come, refinancing to a fixed rate loan may be the better choice. You may pay a bit more in interest than if you let your loan reset, but you’ll be safe from any future interest rate increases (and rates will rise eventually).
Second, what’s the cap on any interest rate rise. ARMs typically have a cap on the rate increase. The cap includes a limit on how much the rate can go up each time the rate is reset and an overall cap on the loan. Understanding your worst case scenario can help you plan, particularly if you do plan to move in the foreseeable future.
Third, what’s the condition of your credit. If you can’t qualify for a great interest rate, you may want to work on your credit score before refinancing. As I’ve written about before, your credit score affects your mortgage rates significantly.
It may be worth letting your ARM reset once to a reasonable rate while you work to improve your score. Once you get your score where you want it, then refi into a fixed rate. Of course, you’ll need to keep on eye on mortgage rates. If they start to edge up, waiting to improve your credit score may not be worth the risk of rising rates.
The bottom line for me is that if you plan to be in your home for a number of years, a fixed rate loan is best. Rates are at an all-time low, making a refinance a fixed rate loan a great option.
Published or updated February 16, 2012.