Is This The Right Time To Refinance Into An Adjustable Rate Mortgage?

Is This The Right Time To Refinance Into An Adjustable Rate Mortgage (ARM)?

Q: I have a question about refinancing my mortgage with a 5-year or 7-year adjustable rate mortgage (ARM).

I know you recently refinanced from an ARM to a fixed-rate mortgage and wondered if it is ever a good idea to do the opposite.

I currently have a 30-year fixed rate mortgage at 5.75 percent, with 24 years left until I pay it off. I just retired from teaching, and plan to return to teaching after taking care of elderly family members for the next few years.

When I return to teaching, my income will be much higher than it is now, and an ARM would allow me to make lower payments during these next few years.

I’m not sure than I will live in this house more than 5 to 7 more years, but am a little afraid of the risk of having to refinance at a much higher rate if I do. I have applied for a 5-year ARM and been approved by a good lender. But I’m wondering if I should take this deal or try to refinance to another 30-year mortgage at a lower interest rate?

A: Here’s my best advice about refinancing: don’t refinance to an adjustable rate mortgage (ARM) at this time.

Mortgage interest rates are at historic lows. Since you don’t know for sure that you are going to sell your home in five to seven years, you are betting that your adjustable mortgage will stay low throughout the time you are in the house. And, if you leave in seven years, you’ll probably be fine.

But what happens if you need to stay another 10 years after that? Let’s say mortgage interest rates are now 8 percent. Will you be okay with refinancing to a 30-year loan at 8 percent? If you are, then you can clearly stomach the risk. What if mortgage interest rates are at 10 percent?

On the other hand, you may want to consider refinancing to a fixed-rate mortgage, even if you have to pay a little bit of money to further buy down the rate on the loan. Right now, you can get a fixed-rate mortgage at 4.75 percent, which is a full percentage point below where you are.

The bonus is that if you decide to leave, your interest rate is so low that you might be able to keep the property as a cash-flow producing investment to help fund your retirement years.

During the real estate boom, people were told that they should get any type of loan because if they couldn’t refinance the loan, they could always sell the property. But, that isn’t always the case (as so many sellers have painfully learned).

You may wind up holding onto the property for a longer period of time and may need the lower payments a longer-term mortgage provides. But as you think about refinancing now, you really need to focus not only on the monthly payment but on the length of the loan. You’re six years into your current loan, your lower payments on any new loan will reflect that lower interest rate but you’ll also pay interest on the loan for six more years than your current loan.

To understand your payment, you really need to know what your monthly payment would be on your new loan if you paid it off over 24 years rather than 30 years. That would give you a better idea of your actual savings per month. You could then pay that higher amount and end up paying off the loan at the same time as your current loan. Finally, most ARM loans have some limits to their increases.

If your new 5-year ARM loan starts out at 4.25 percent, your interest rate may not increase by more than 2 percent in the sixth year. Thereafter, the rate may not go up or down more than 2 percent per year and over the life of the loan, the interest rate may be capped at 9.25 percent or 10.25 percent depending on the loan program you are in.

Make sure you understand the terms of the ARM loan and make sure you understand how the interest rate can change and what the interest rate is based on.

In years past, many ARM loans floated along with the United States Treasury rates, but later other indexes were used, including LIBOR (the London Inter Bank Offer Rate). LIBOR and the Treasury rate seemed to have moved with the market and have not had too many hiccups, but some other indexes have skyrocketed at times hurting borrowers who were tied to those indexes.

Think carefully about this decision. My vote is for a fixed-rate mortgage unless you know for sure you’re going to sell in seven years.