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Updated on Monday, February 4, 2019
Should you go with an adjustable-rate mortgage, or ARM, for a lower initial interest rate or a fixed-rate mortgage for long-term security? That’s a question many ponder when buying a home. But for those who already have an ARM that may be adjusting soon, rising rates may trigger the need to explore a fixed-rate refinance option.
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ARMs are different from fixed-rate mortgages in that they offer a low initial, or “teaser,” interest rate for a period of time — typically three, five, seven or 10 years — that then adjusts to the current rate. Rates for ARMs are typically lower than fixed-rate loans, making them attractive to a range of borrowers, such as first-time buyers who need a lower rate to be able to purchase; borrowers who intend to live in their home for only a few years and to sell before their rate adjusts; and those who may be able to safely predict future salary increases to cover what likely amounts to a higher rate later on.
Mortgage rates are expected to rise throughout the next year, and that uncertainty may bring a desire for a little control. Freddie Mac has forecast 30-year fixed loans to climb above 5% in 2019 — a figure we haven’t seen since 2011 — and the Federal Reserve’s announcement that benchmark interest rates will go up again this year has those homeowners whose ARMs are adjusting soon taking note.
Advantages of refinancing from an ARM to a fixed-rate mortgage
A fixed-rate loan offers several benefits to borrowers and may be especially prudent for those who are looking for a more conservative option than their ARM.
Reduce interest rate risk. Yes, ARMs offer a low initial rate, but once they adjust, borrowers can be in for an unpleasant surprise. In fact, Fannie Mae has a specific policy designed to protect buyers from what it calls “payment shock — the impact on the borrower’s ability to continue making the mortgage payments once the introductory rate expires” by qualifying buyers not just on their payment during the introductory rate, but on an amount that better predicts the post-adjustment payment.
Allows you to create a stable budget. One of the advantages of knowing what your mortgage payment is going to be every month is that it allows you to create a long-term budget and financial plan. Budgeting is difficult enough if you don’t know your firm costs, and only estimating what your most significant expense will be can keep you from creating a stable budget and setting goals. Having a solid budget also allows you to be better prepared for surprises and emergencies.
“An ARM is adjustable, which means the rate can go up,” said Tendayi Kapfidze, chief economist at LendingTree, which owns MagnifyMoney. “With a fixed-rate mortgage, you know what the rate is going to be. You know what your payment is going to be. It’s not going to change.”
People who are planners also may have interest-rate anxiety if their rate is adjustable. All the “what ifs” related to potential future rate increases can be hard to endure. If your adjustment period is still far away and you’re already starting to panic, it may be a good time to review your options.
Potentially lower your interest rate
While there is the possibility that your interest rate will rise initially when you transition from an ARM to a fixed-rate loan, the advantage is in escaping the possibility of significant financial harm down the line. For many people, the jump from their current rate to the adjusted rate would be enough to hamper their finances. Not only is a fixed rate less risky, but it can also offer long-term savings by avoiding adjustments.
Of course, rates on ARMs can’t increase boundlessly; limits are in place that govern both annual increases and those over the life of the loan. For instance, on Federal Housing Administration one- and three-year ARMs, the rates can go up by 1 percentage point each year after the expiration of the initial rate period, and no more than 5 over the entire loan. But, even a 1-point increase can be enough to create affordability issues for those who are already financially stretched.
Downsides to refinancing your ARM
While there are many advantages to refinancing out of an ARM, doing so is not for everyone. If you tend to be more aggressive financially or are willing to take a gamble on rates staying stable, you may want to ride out your ARM until the last possible moment — and may even want to look into refinancing to another ARM at that point (more on that later).
For those who opt not to refinance at all, that decision is often due to a few potential drawbacks.
Upfront costs. As with almost any refinance, consider the fees involved because they can lower the cost benefit. You can expect to pay between 2% to 6% of the total amount you’re borrowing in closing costs. This covers things like application and origination fees, title insurance and inspection fees. You will most likely also need to pay for an appraisal, so the lender can determine the exact value of your home today. Total costs will vary, depending on where you live, and also can be different lender to lender, which might help you choose one over the other.
Interest-rate changes could be negligible. There are widespread predictions about interest rates rising in 2019, but, for now, they’re just predictions. “Some people play a game of predicting where they think rates are going to go, but I wouldn’t advise that,” Kapfidze said. “People on Wall Street are doing that every day. It’s about your personal risk profile and how comfortable you feel with interest-rate risk.”
A higher monthly payment. Borrowers who choose adjustable-rate loans often do so for the lower interest rate and lower payment, so the idea of a higher payment after switching to a fixed-rate mortgage won’t thrill them. But is the peace of mind of a fixed payment worth the higher amount? “Initially, the payment on a fixed loan may be higher than on an ARM, but, again, you’re eliminating the risk of your payment changing going forward,” Kapfidze said.
Breaking even. If you’re several years into paying your mortgage, you may not relish the idea of going backward. You can calculate your break-even time — the amount of time it will take to recover from the cost of refinancing — to help you decide whether this type of refinancing is a smart decision.
Refinancing to another adjustable-rate mortgage
The reasons you opted to go with an ARM — greater purchasing power with a lower rate, not planning to stay in the house long — might still be in play. In that case, it may make sense to refinance your soon-to-adjust loan to another ARM.
The most recent data from Freddie Mac shows 30-year fixed mortgage rates at 4.45% and a 5/1 ARM at 3.83%. An ARM could save you a considerable amount of money, but in a few years, you may find yourself in the same position again, looking to refinance into a more stable loan with fixed payment for a longer term. And there’s no telling what could happen to rates in the meantime.
Take your chances, or take control of your finances and your future in an uncertain time? For many, that’s the question posed by their adjustable mortgage. With a number of options for refinancing, from an ARM to a fixed-rate loan or to another ARM, buyers have a number of factors to consider, not the least of which is whether they want to refinance at all.
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