Adjustable rate mortgages (ARMs) make homeownership more accessible for some borrowers. They offer the advantage of a lower interest rate for an introductory period, making the monthly mortgage payment more affordable. But when this period ends, the rate becomes variable, which might strain your budget and prompt the desire to refinance.
Is it an option, though, with this type of mortgage? Read on to learn more about how refinancing an ARM works, along with the potential benefits and drawbacks of doing so and what to consider before moving forward.
What Is an Adjustable Rate Mortgage (ARM) Loan?
As the name implies, an adjustable rate mortgage (ARM) is a type of home loan with a fluctuating interest rate. The main draw is that you get the luxury of a fixed rate during the initial period—often the first 3, 5, 7, or 10 years—to make your housing costs more manageable. However, the fixed rate is followed by a variable rate for the remaining loan term.
Interest rate changes occur at predetermined intervals and are based on current market conditions. Depending on the terms of the loan agreement, you can expect your rate to change monthly, annually or semi-annually. Rate caps apply, which limit how much the interest rate can fluctuate when adjustments are made.
Adjustable Rate (ARM) vs. Fixed Rate Mortgage Loan
When shopping for a mortgage, you have two primary options: an adjustable rate or a fixed-rate loan. Both can help you accomplish your homeownership goals, but there’s a primary difference.
As described above, an adjustable rate mortgage comes with a fixed rate to start, followed by a rate that adjusts based on market trends. This means your monthly mortgage payments will change over the life of the loan.
By contrast, a fixed-rate mortgage gives you a set interest rate for the duration of the loan term. Your monthly mortgage payments (principal and interest) stay the same, and you’ll know your total borrowing costs upfront.
Can You Refinance an Adjustable Rate Mortgage (ARM) Loan?
You can refinance your adjustable rate mortgage (ARM) into a different loan type. Many homeowners refinance into fixed loans to lock in a set rate and avoid future increases. Doing so also helps minimize interest costs over time.
Refinancing an ARM Loan: Sample Scenario
To illustrate how ARM refinancing works, assume you have a 5/1 ARM loan with a starting balance of $300,000 and an initial interest rate of 4%. Your initial monthly payment, interest and principal combined is approximately $1,432. As you approach the end of the five-year fixed-rate period, you consider refinancing.
If you opt for a 30-year fixed-rate mortgage with a 5% rate, your new monthly payment will increase to $1,610. But if you choose a new ARM with a 3.75% introductory rate, it will be $1,389.
By refinancing into a fixed-rate mortgage, your monthly payment would increase, but you’d have the security of a steady rate through the life of your loan. On the other hand, if you choose to refinance to another ARM, you might benefit from a lower initial rate, but with the risk of future rate adjustments.
Remember, the actual rates and payments will vary based on current market conditions, your credit score, and other factors. It’s essential to run the numbers for your specific situation and consider future rate adjustments when deciding whether to refinance your ARM loan.
What Are the Potential Benefits of Refinancing an ARM Loan?
Here are some key advantages associated with refinancing an ARM loan:
- Stable Monthly Payments: By locking in a fixed rate, you ensure your monthly payments remain unchanged for the life of the loan.
- Potential for Lower Interest Rates: If you can refinance to a lower interest rate than your current ARM, you could reduce your monthly payments and save money over the long term.
- Long-Term Savings: A fixed-rate loan could result in less interest paid during the loan term than an ARM, especially if interest rates rise.
- Planning and Budgeting: The consistency of a fixed-rate loan makes it easier to budget for your monthly mortgage payments.
What Are Some Potential Downsides or Risks in Refinancing an ARM Loan?
As with any home loan refinance product, there are also downsides to consider:
- Closing Costs: Refinancing typically involves closing costs that can outweigh the savings from a lower interest rate, depending on how long you plan to stay in your home.
- Interest Rate Environment: If you refinance when interest rates are high, you could end up with a higher rate than your original ARM.
- Lost Benefits: Some ARM loans have features like rate caps or conversion options that may be lost in refinancing.
- Extending Loan Term: You may decide to extend the term of your loan, which gives the lender more time to collect interest.
- Equity Dilution: If you opt for a cash-out refinance, you reduce your equity stake since you’re borrowing against your home.
Key Considerations Before Refinancing an ARM Loan
If you’re sold on the idea of refinancing your ARM, evaluate these factors before formally applying with a lender.
Understanding the Terms of Your Current Loan
Confirm the specifics of your current ARM, including the interest rate and the length of the initial fixed-rate period. Your current ARM may have attractive terms that could be disrupted by a premature refinance.
You should also know how often your interest rate adjusts. This could affect how soon you need to refinance to a fixed-rate loan to maximize cost savings.
Deciding the Best Time to Refinance
Track the market trends closely, as they influence the interest rates available to you. Refinancing to a fixed-rate mortgage makes sense when interest rates are relatively low and are expected to rise.
It’s equally important to consider the stability of having a fixed-rate mortgage compared to the potential uncertainty of future rate changes with an ARM.
Evaluating the Cost and Savings
Remember, refinancing involves fees and closing costs that can add up. Itemize these potential costs and weigh them against long-term savings.
Calculate the time it will take for the monthly savings from the new fixed rate to cover the refinancing costs. This figure is vital in determining whether refinancing your ARM loan is financially beneficial or whether you should hold off.
How to Refinance an ARM Loan
Once you’ve familiarized yourself with the pros, cons and important considerations associated with refinancing an ARM, here’s how to move forward:
- Review your current loan: Understand your ARM’s terms, including the index, margin and rate caps.
- Check your credit score: A higher credit score may qualify you for a lower interest rate, leading to significant cost savings over time.
- Compare lenders: Each lender will have different rates and fees, so finding one that offers the best deal on a refinance is essential.
- Submit your application: Once you’ve selected a lender, complete your application.
- Gather financial documents: Be prepared to provide documentation related to your income, assets and current mortgage.
- Lock in your rate: You may be allowed to lock in the interest rate, which can protect you from rising rates during the lending process.
- Close on the new loan: After your application is approved, the final step is closing, which involves signing paperwork and paying closing costs (unless you roll them into the new loan).
Is Refinancing an ARM Loan Right for You?
Refinancing an adjustable rate mortgage (ARM) can be a sound financial decision, depending on your personal circumstances and financial goals. It could make financial sense in these situations:
- Your ARM’s low introductory rate is about to expire, and you’re facing a rate hike.
- Interest rates in the market are favorable, and you qualify for a lower fixed rate.
- You plan to stay in your home for a bit and want protection from future rate increases.
- You’ll remain in your home long enough for the benefits of refinancing to outweigh the closing costs.
Conclusion: When to Refinance an ARM Loan
Refinancing your ARM loan is a strategic decision that can potentially offer stability and savings, especially as the fixed-rate introductory period comes to an end. If you are nearing the point where adjustable rates will kick in, and market trends suggest rising interest rates, consider a refinance to a fixed-rate mortgage to lock in a consistent payment for the rest of your loan term.
FAQs About Adjustable Rate Mortgage (ARM) Loan
To convert your ARM to a fixed-rate mortgage, you need to go through the refinancing process. It involves taking out a new mortgage with a fixed rate that pays off your existing ARM. The ideal time to refinance is before the end of the initial fixed-rate period, especially if you anticipate a significant rise in interest rates.
Choosing a 5-year ARM could be a good idea if you plan to sell your home or refinance before the fixed-rate period expires. It typically offers a lower rate initially compared to a 30-year fixed-rate mortgage, which can save you money in the short term. However, be mindful of the potential for a fluctuating interest rate that can translate to significant borrowing costs if you’re unable to refinance before the initial period.
Yes, ARM loan rates can go down depending on current market conditions. An ARM’s interest rate is typically tied to a financial index plus a margin, meaning your rate and payment could decrease if the index falls.
Yes. You can refinance out of an ARM into a fixed-rate loan to secure a fixed interest rate and set monthly payments. This might be a strategic move if you want the stability of fixed monthly mortgage payments or if you anticipate an increase in market rates in the near future.
