Refinancing your ARM when it’s about to reset

ARMs resetting to highest rate since 2008

Is your (ARM) about to adjust? You may not want to allow that.

At current mortgage rates, today’s ARMs are resetting near 5%, which is the highest since 2008. Gone are the days when you got a lower rate by letting your ARM adjust than by refinancing.

Prior to 2016, it’s paid to have a conventional adjustable rate mortgage. Today, not so much.

If you’ve been riding your ARM through its adjustments, you’ve benefitted from low rates. With market sentiment shifting, though, it’s time to consider refinancing into something different—either a new ARM or a fixed-rate loan.

ARMs are expected to adjust higher in 2019 and 2020.

How does an adjustable-rate mortgage (ARM) work?

An adjustable-rate mortgage is a mortgage for which the interest rate can change (i.e. adjust) over time-based on “market conditions”.

Sometimes, ARM mortgage rates adjust higher. Sometimes, ARM mortgage rates adjust lower. And, .

However, ARM interest rates fluctuate for the homeowners who use them, ARMs carry a financial risk not present with fixed-rate loans. For example, when you use an ARM to finance your home, there is no way to know what your mortgage rate will be in 10 years.

Uncertainty can be frightening. It can be hugely rewarding, too.

Consider this: since 2003, nearly every U.S homeowner using a conventional ARM home loan “beat the bank” on their mortgage. This is because, between 2003 and late-2015, adjustable-rate mortgages adjusted below the rates you could get on a “brand-new” loan (and with no closing costs required!).

That streak ended in December 2015, though, when the Federal Reserve from its target range near zero. When the Fed raises the Fed Funds Rate, it can affect the drivers for an adjusting ARM.

As a quick refresher, here’s how adjustable-rate mortgages work.

1. For a fixed period of time, usually 5 or 7 years, your mortgage rate is constant
2. When the fixed period ends, your rate adjusts according to a preset formula
3. Once annually thereafter, your rate adjusts using the same preset formula

The preset formula is a simple one. The new rate for the adjustable-rate mortgage is the sum of some variable market rate — typically the 12-month LIBOR — and a predetermined constant, which is typically 2.25 percent.

Adding the constant and the variable shows your new rate. For instance, if the LIBOR were 2.8%, that sum is (2.25) + (2.8), or 5.05%.

5.05% is a low mortgage rate, but it’s higher than what you could get for a new 5-year ARM from an approved mortgage lender. According to Freddie Mac, new 5-year ARMs average 3.80 percent nationwide at the time of this writing.

However, with a new ARM, there are closing costs to pay.

For example, in order to lock the 3.80 percent 5-year ARM rate shown by Freddie Mac, borrowers are expected to pay 0.5 to the lender. And, closing costs apply, too.

If you prefer to let your loan adjust, you won’t get access to the 3.80% rate — but you won’t be responsible for closing costs, either. This is because, with an adjusting loan, there are no appraisals, no verifications of your income, and no credit check required.

In addition, an adjusting loan requires no underwriting and no fees paid to title companies. You’re not even required to have a job.

So, there are reasons to refinance away from your adjusting ARM, but allowing an adjustment can make sense to your cash flow, too.

Should you refinance from ARM to fixed?

If your current loan is an adjustable-rate mortgage and the loan is about to adjust, you have a decision to made as a homeowner — should I let my ARM adjust or should I refinance it?

In all, there are three options for your adjusting ARM :

1. Do nothing. Let your loan adjust; revisit mortgage rates again next year
2. Refinance your ARM to a new ARM at today’s ARM mortgage rates
3. Refinance your ARM to a new fixed rate loan at today’s fixed rate pricing

Each option has merits.

Option 1

If you allow your ARM to adjust (Option 1), your lender will assign a new mortgage rate based on a common index such as the LIBOR (but note that the LIBOR index is going away in 2021 and banks will start using a different index.) Most homeowners will get a rate near 5.05% which will be assigned for the 12 months. The payment on a 5.05% mortgage rate is $540 for every $100,000 owed.

Option 2

You can also refinance your ARM into new adjustable-rate loan.

Via a new ARM, you can lock your rate for the next 5 or 7 years or longer, depending on your needs. You’ll postpone the adjustments of a recasting ARM and, according to Freddie Mac’s most recent mortgage rate survey, will get an average rate of 3.80% for a 5-year ARM for an accompanying, one-time fee of 0.5 discount points plus your lender’s closing costs.

The payment on a new ARM is $465 per $100,000, which saves $75 monthly but which is also subject to closing costs which could add up to the thousands, depending on in which state you live.

Option 3

Lastly, you have the option of switching your ARM into a fixed-rate loan.

This is the most common way homeowners remove the uncertainty of “changing mortgage rates” and, according to quarterly refinance reports from the government, more than half of homeowners with ARMs make this choice.

Refinancing your ARM into a fixed-rate loan can be a good fit for several reasons — especially if you expect that the economy will improve this year or next, and you plan to stay in your home for a few more years.

An improving economy moves LIBOR rates higher and LIBOR is the basis for your adjusted ARM mortgage rate. With a fixed-rate mortgage, you’ll get a stable monthly because your interest rate is fixed and so is your payment.

The downside is that fixed-rate mortgages are roughly 100 basis points (1.00%) higher than comparable ARM mortgage rates, which means that your “stable payment” might be higher than your adjusted one.

Refinance your ARM to another ARM

Before you refinance your ARM, you need to know a couple of things:

• How long do you expect to keep your loan now?
• What are your ARM interest rate and payment likely to be?
• Will you save money by refinancing?
• Can you sleep at night without a fixed loan?

If the answer to the last question is a resounding “no,” get yourself to a lender and get yourself a fixed-rate refinance.

End of story.

However, if you expect to have your home and your mortgage for just a few years more, you may save a ton, again, with a new 3/1, 5/1, 7/1 or 10/1 ARM.

Your first step is determining what would happen to your ARM if it were adjusting today, and what it’s likely to do in the near future.

To do this, you need to look at your loan paperwork and find your loan’s index, margin and caps.

Suppose you have an ARM with a two-percent-per-year cap, a 2.25 percent margin and a five percent lifetime cap. Today’s LIBOR index is near 2.8% percent, so if your loan were resetting today, your new rate would be 5.05 percent. If your current rate is 3.0 percent, your increase is only 2.00 percent (not the full increase of 2.05% because of the 2.0% cap). That new 5.0% rate is good for another year.

But what about subsequent years? Here are a few more figures for you.

• The median value of the 1-Year LIBOR is currently 2.8%. If your loan were resetting based on that value, your new rate would be 5.0 percent (remember that you are at 3.0% and there’s a 2.0% yearly cap).
• The highest rate your loan could hit at its next adjustment is 7.0 percent because your per-year adjustment cap is two percent.
• The highest rate your loan could reach in its lifetime is 8.0 percent, because its lifetime cap is five percent.
• Housing authorities believe that by the end of 2019, the average 30-year fixed-rate mortgage will rise to around 5%.

Right now, ARMs just don’t look that scary.

An in-depth explanation of ARM caps

Dig out your loan agreement, and there’s a very good chance you’ll discover up to three sorts of caps that limit the amount your rate (and therefore your payments) can rise.

These caps vary from mortgage to mortgage, so you need to do a bit of reading to find the protections yours provides.

Periodic adjustment caps

The first sort is intended to prevent sudden hikes that could be hard to absorb in your household budget. It sets a top limit (often two percent) on the amount by which your mortgage rate can rise each year.

You’ve probably seen these mortgages described as 3/1 ARMs, 5/1 ARMs, 7/1 ARMs and similar. The first number specifies the initial fixed-rate period in years, and the second shows (again in years) how often hikes are allowed after that. So a 5/1 ARM has five years fixed, and then permits rate increases every one year.

Payment caps

The second type of cap applies to your monthly payments rather than interest rates. It might, for example, say those monthly payments can’t rise at any one time by more than a certain amount.

Suppose that particular cap is set at 7.5 percent in your loan agreement, and you’re currently paying $1,000 a month. At most, you’d pay an extra $75 a month when your next hike is implemented.

Lifetime caps

The third sort of cap limits the amount by which your interest rate can rise in total over the lifetime of your loan.

Check your caps, and use The Mortgage Reports mortgage calculator to model how different rate increases might impact your payments.

These three types of cap together mean that even if interest rates suddenly soar, your exposure doesn’t. That doesn’t mean you won’t face some pain, but it’s probably less scary than you think.

How long will you keep your home and loan?

The first question may be the most important. If your current home is your “forever home,” a fixed-rate mortgage might be your best bet, because it gives you the certainty and security of knowing your first monthly payment will be the same as your last: You know, the one when you become mortgage-free.

But if you’re likely to move or refinance again anyway sometime in the next few years, it may not be worth paying the higher rates that typically come with fixed rates.

So how likely is it you’ll move again to a new job? Perhaps to somewhere bigger to accommodate more kids or aging parents? Or to a downsized home? Maybe to a smarter neighborhood? Or, heaven forbid, to a post-divorce home?

Few people can answer those questions with total certainty. But your best guess could save you paying too high a rate for either an FRM or a longer-than-necessary fixed-rate period on your new ARM.

Adjustable-rate mortgages can be “safe”

An adjustable-rate mortgage is a mortgage for which the interest rate can change over time. Commonly abbreviated as “ARM”, the adjustable rate mortgage is the opposite of the fixed-rate mortgage.

Adjustable-rate mortgages are available for most common loan types. You can use ARMs for conventional financing via Fannie Mae and Freddie Mac; and with FHA loans and VA loans, too.

Only USDA loans prohibit the use of adjustable-rate financing.

The rules for how an adjustable-rate mortgage include two very important points. First, because the mortgage rate of an ARM doesn’t change during its initial “teaser” period, during these first few years, an ARM behaves identically to a fixed-rate mortgage.

Second, when an ARM enters its adjustment phase, there are rules which govern by how much it can adjust in any given year. 5-year ARMs, for example, are capped to adjustments of ±2% per year, with the rate never allowed to move more than six percent from its starting rate.

As an illustration, with a 5-year ARM, the ARM mortgage rate remains unchanged for the first 60 months, and then it can adjust. The new mortgage rate after 60 months is equal to the then-current 1-Year LIBOR rate, plus 225 basis points (2.25%).

With LIBOR currently near 2.8, today’s ARMs are adjusting to near 5.05 percent.

Keep in mind, though, that there are limits to how much the rate can rise.

A loan with an initial rate of 3.25% can never rise more than 9.25% if it has a 6% lifetime cap (3.25% + 6% = 9.25%).

Rates for an ARM can never reach 20%, nor can they fall to zero. They can only move within six percentage points of the original starting rate. There is safety in today’s ARMs — you always know the maximum by which your rate can change on its adjustment dates.

Get today’s mortgage rates

For U.S. homeowners with adjusting adjustable-rate mortgages, the best “refinance move” may be to skip the refinance entirely. You’ll have to compare mortgage rates and see what’s best for you.

Compare fixed and adjustable refinance rates from top lenders to get your best value.