You see a lot on the news these days about people refinancing adjustable rate mortgages (ARMs) in order to avoid rate adjustments and higher mortgage payments.
In fact, the federal government has cited ARM loans made to poorly qualified borrowers as being a major contributor to the current rise of mortgage foreclosures in the
But how do adjustable rate mortgages relate to refinancing and foreclosures? Should you refinance your ARM loan in order to avoid "payment shock"? If so, what's the best way to go about refinancing your adjustable rate mortgage?
These are some of the questions we will tackle in this article -- a guide to refinancing the ARM Loan.
How Adjustable Rate Mortgages Work
Before we talk about refinancing aspects of the adjustable rate mortgage, let's talk about what an ARM loan is in the first place. For those of you who currently have an ARM loan, you'll probably be well versed in what I'm about to explain. This part of the article is mainly for those of you who have not experienced an adjustable rate mortgage firsthand.
As the name implies, an adjustable rate mortgage differs from a fixed rate mortgage in the way it adjusts to a new (and usually higher) interest rate at some point in the future. Fixed rate loans have the same interest rate through the entire life of the loan. On the other hand, with an adjustable rate mortgage, the interest rate will change periodically. This can cause payments to go up or down (usually up), depending on the prevailing rate at the time of adjustment and other factors.
Most ARM loans fall into the 30-year category. During the first phase of the loan, you will normally pay a fixed interest rate. This initial period is usually 3, 5 or 7 years, but can vary based on the mortgage lender, the mortgage program, etc.
The Appeal of ARM Loans
The interest rate during the ARM's initial fixed-rated period is usually lower than the interest rate on a regular fixed-rate loan. And of course, a lower interest rate leads to a lower overall mortgage payment each month (with all other things being equal).
This is the primary appeal of the adjustable rate mortgage loan. But as with many things in real estate finance, there is a big downside to the ARM loan. This downside obviously has to do with the uncertain future of an ARM, and this is what leads many people to refinance their adjustable rate mortgage for a fixed rate instead.
When the ARM Loan Adjusts
After the initial period (3, 5, 7 or however many years), the interest rate on the ARM loan will adjust to whatever the current interest rate is at the time of adjustment. Here's the key to this -- you never know in advance what the interest rates will be 3, 5 or 7 years down the road. They might be higher, they might be lower. That's the uncertainty of an adjustable rate mortgage.
What to keep in mind:
Unlike a fixed rate mortgage, the payments on an adjustable rate mortgage can change. This can increase the size of your mortgage, sometimes significantly.
You cannot predict what the interest rates will do three or five years from now, when your ARM loan adjusts.
It's possible that you could eventually owe more money than you borrowed.
If you want to pay off your ARM early to avoid payment increases, many lenders will charge a penalty fee for it.
Adjustable Rate Mortgages and Payment Shock
The media loves to use the phrase "payment shock" because it sounds so dramatic. But without proper planning, homeowners can truly be shocked by their ARM loans when the rate adjusts. This is what happens when your mortgage payment rises steeply during a rate adjustment.
Let's look at an example scenario. Imagine you took out an ARM loan for $200,000. During the first year(s) of an ARM, you'll usually enjoy a very low interest rate. As mentioned above, that's the primary benefit / appeal of the adjustable rate mortgage. So let's say you start out with a 4 percent interest rate that later goes up to a 7 percent interest rate (after the second year). During the first two years, the mortgage payments would be somewhere in the neighborhood of $950 per month. But after the adjustment at year two, those payments would go up to more than $1,300. That's a big difference.
Refinancing the ARM Prior to Adjustment
The usual strategy with an adjustable rate mortgage is to either refinance the ARM loan or sell the home prior to the adjustment. By doing one of these two things, the homeowner can enjoy the lower interest rate for the initial period, while avoiding the uncertainty of the adjustment period.
This is why adjustable loans are popular among home buyers who do not plan to stay in a home more than a few years. They can get the advantage of a lower rate up front and then sell the home (or refinance the ARM loan) down the road.
Trading the ARM for a Fixed Rate Mortgage
Most people who refinance their home mortgage loan these days do so in order to trade their adjustable rate mortgage for a fixed rate loan. If done right, this type of refinancing can save you money while also giving you the much-desired stability of a fixed rate loan.
If you want to enjoy the predictability and financial security of paying the same rate over the life of your mortgage loan, the fixed rate mortgage is the only way to go. After all, if you are refinancing your adjustable rate mortgage to avoid the uncertainty of rate adjustments, the last thing you want to do is take on another ARM loan!
Is Refinancing Right for You?
You shouldn't automatically assume that refinancing your ARM loan is the right thing to do. It could very well be the best option for you, but you should still do the math, research the subject further, and seek professional financial advice.
Here are some articles on our website that will help you determine if a mortgage refi is right for you:
Should I Refinance My Mortgage Loan?
Mortgage Refi Costs Explained
When NOT to Refinance a Home Mortgage
by Brandon Cornett
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