Is It Time to Consider Refinancing to an Adjustable-Rate Mortgage (ARM)?

Chances are, if you purchased a home a few years ago, your current mortgage loan has a relatively low fixed interest rate. But if you bought one more recently, especially in the current higher interest rate climate, you may benefit from an ARM refinance under the right circumstances.

Take a moment to better understand what an ARM is, how it works, the benefits and drawbacks of refinancing to an ARM, good candidates for doing so, and what to expect with the ARM refinance process.

In this article (Skip to…)

• How does an ARM loan work?
• Pros and cons of refinancing to an ARM
• Candidates for refinancing to an ARM
• The bottom line

How does an ARM work?

An adjustable-rate mortgage, also known as an ARM, is a type of loan that initially provides a stable and low fixed interest rate for a limited period. During the introductory fixed-rate phase, your interest rate and monthly mortgage payment remain stable and unaffected. After this initial period ends, the interest rate and mortgage payment can go up or down depending on housing market conditions. If interest rates rise, your payment amount will also increase.

Nevertheless, the advantageous low introductory rate of an ARM can initially reduce your monthly mortgage payment and enhance your ability to purchase a home that you can always attempt to refinance or sell before the new ARM’s initial fixed-rate phase ends.

There are several common options for ARMs, such as the 3/1, 5/1, 7/1, and 10/1 ARM. The first number represents the duration of the fixed-rate period. For example, a 5/1 ARM entails a fixed-rate period of five years. The second number (in this case, “1”) indicates the frequency of potential adjustments to your interest rate. Using the 5/1 ARM as an example, after the fixed-rate phase, your interest rate could change annually.

Typically, most ARMs have a total loan term of 30 years. In the case of a 5/1 ARM, you would enjoy a five-year introductory period, followed by 25 years during which your interest rate and payment can potentially adjust each year. It is worth noting that modern adjustable-rate mortgages include interest rate caps, which limit how high your rate can rise. This ensures that the cost does not continually increase for 25 years but instead reaches a cap specified in your loan program agreement.

The pros and cons of refinancing to an ARM

Refinancing to an ARM offers one main advantage: You can save money by benefiting from the initial rate reduction. Say you refinance your home, which has a $250,000 balance, from a 30-year mortgage with a fixed interest rate of 7.0% to a new 5/1 ARM with an initial fixed interest rate of 5.5% and a new 30-year term. For the first five years of your ARM, you can expect to pay $1,419 a month in principal and interest; that’s $244 lower than the $1,663 you were paying on your original fixed-rate mortgage loan.

Keep in mind, however, that today’s ARM initial fixed interest rates are not quite as generous as the above scenario. At the time of this writing, according to the Mortgage Bankers Association, the average contract interest rate for a 5/1 ARM is 6.76% versus an average 7.61% rate for the benchmark 30-year fixed-rate mortgage.

Currently, that’s not a wide spread. But Brandon Mushlin, creative strategist with BuildBuyRefi.com says ARM rates during the initial fixed interest phase “can often be 1% to 2% lower than current comparable 30-year fixed rates.”

The most serious downside to an adjustable-rate mortgage is that “the rate changes after the initial fixed-rate period, depending on the market,” cautions J. Keith Baker, a real estate professor at North Lake Campus of Dallas College in Irving, Texas. “If you end up with a much higher interest rate after the adjustment period begins, there’s always the risk that you will not be able to afford your monthly payments.”

Another drawback? Once the interest rates begin to fluctuate, it may be harder to budget for or forecast the money you’ll need to afford your future mortgage payments.

“This can potentially cause financial stress if you stay in the home longer than planned,” says Dennis Shirshikov, strategist at Awning.com and professor of economics and finance at City University of New York.

Additionally, you will need to pay closing costs when you refinance. These can often equate to 2% to 5% of your loan amount. So it may only make sense to refinance to an ARM if you can secure a lower interest rate and significantly reduce your monthly mortgage payments. This can allow you to recoup your closing costs more quickly.

Good candidates for an ARM refinance

The best prospects for considering a mortgage refinance to an ARM are those who expect to move or sell their home before the initial fixed period ends.

“These folks can benefit from the lower initial interest rate without the risk of rate increases later,” Shirshikov notes.

Mushlin believes that “homeowners who have current fixed rates of around 6% to 7% or higher, who have earned some equity in their home, have owned the property for at least 12 months, and have opportunities for low closing costs” should consider pursuing a refinance to an adjustable-rate mortgage.

Scott Lieberman, founder of Touchdown Money, says you should also ponder a refi to an ARM if you think you’ll pay the ARM off before the fixed-rate period concludes.

“Let’s say you are waiting on a major financial windfall or you are expecting a big raise,” explains Lieberman. “If you know you’ll use the money to pay off your mortgage, why not save in the short term by getting the lowest possible rate?”

But if you plan to stay in your home for a long time, “or if your financial situation is such that a potential increase in your mortgage payment would be difficult to manage, refinancing to an ARM may not be a good choice,” adds Shirshikov.

Steps involved an ARM refinance

The process of refinancing to an ARM is similar to any other refinance.

“It includes shopping around among several different lenders and requesting rate quotes and loan offers, choosing a lender, submitting a loan application, going through underwriting, and closing the home loan,” says Shirshikov.

Just make sure you fully understand the terms and conditions of the ARM, “including the maximum possible rate once the rate adjustment period begins, when it can change, and by how much,” he adds.

The bottom line

Weigh your loan options carefully before committing to a new loan and a refinance. Realize that you may save money within the first few years after refinancing to an adjustable-rate mortgage, but you also have to pay closing costs that will need to be recouped relatively quickly (in the form of lower monthly mortgage payments) to justify the refinance.

When in doubt, shop several different mortgage lenders and consult with an experienced lending professional, certified financial planner, or other trusted financial source.