Should You Refinance Into An Adjustable-Rate Mortgage (ARM)?

As in many areas of life, people often prefer certainty when it comes to their mortgage payment. For this reason, the idea of going with an adjustable-rate mortgage (ARM) is often dismissed out of hand. However, there are certainly reasons to consider it, particularly if you’re refinancing to save money. We’ll discuss the pros and cons of an ARM refinance, but let’s start with the basics.

What Is An Adjustable-Rate Mortgage (ARM)?

An adjustable-rate mortgage is a type of home loan with a mortgage rate that changes over time. This differs from a fixed-rate mortgage where the principal and interest in your monthly payment remain constant throughout your loan term.

How Do ARM Loans Work?

ARMs have a fixed-rate period at the beginning of the loan. During this time frame, often lasting for the first 5, 7 or 10 years of the loan, your interest rate remains unchanged. After that, the rate adjusts up or down based on financial markets.

How often the rate can adjust up or down depends on the terms of the mortgage. There are also rate caps and floors in place within your mortgage agreement (that set the maximum possible rate, as well as the minimum possible rate). These protect borrowers because the rate can’t go up or down more than a certain percentage with the initial adjustment, subsequent adjustments or over the life of the loan.

Example ARM Loan Scenario

Let’s say you have a $300,000 loan with a 5-year ARM with a 3% mortgage rate. After the 5-year fixed period, the mortgage rate can adjust once a year. There’s an initial cap or floor on adjustment of 2% along with a 2% cap or floor on every adjustment after that. Finally, at no time will your interest rate go up or down more than 5% over your loan term.

This particular type of ARM that adjusts once per year with those caps would be advertised as a 5/1 ARM with 2/2/5 caps.

Here’s one scenario for how things might play out over the first 8 years of the mortgage on a 30-year term.

If you’re looking to possibly refinance into an ARM, it’s important to understand the terms, in particular how often the rate adjusts and the caps. You may also want to know what index your ARM is tied to and the lender margin.

Pros Of An ARM Refinance

There are certain situations in which it definitely makes sense to consider refinancing into an ARM. Let’s run through a couple of them.

• You don’t plan on staying in your home long-term. If you only plan on staying in your home a few more years, you can get a lower rate than current fixed rates with an ARM and move out before the rate ever adjusts. The longest fixed period on an ARM is typically 10 years.
• You have a large loan. The larger a loan, the more money a client can save during the fixed-rate period. It’s simple math. This makes ARMs a top choice of financially savvy clients who stand to save exponentially more on interest with a lower initial ARM rate as compared to a 30-year fixed rate.
• Interest rates are running higher. When interest rates are running on the high side, getting into an ARM may make more sense because you’re getting an interest rate lower than current fixed rates for the first several years of the loan.
• You plan on paying down your balance. Some people use an ARM as a financial hack. Knowing that they can get a lower rate for the first several years of their loan, they’ll make regular extra payments toward their principal so that they can really pay down their mortgage.

Cons Of An ARM Refinance

There are downsides to an ARM refinance. Let’s run through them.

• You plan on staying in your home long-term. If you stay in your home long-term, you’re opening yourself up to adjustment if you don’t refinance. While it’s true you could very well be able to refinance down the line, you also don’t know what your financial situation or the market will be like projecting into the future. A fixed rate can provide certainty, but that certainty comes with a price (a higher rate).
• You just want to make your regularly scheduled payments. While making extra payments toward your mortgage balance can be a good thing to do, it’s also a major financial commitment. If you have other financial concerns like paying for a new car or paying back college debt, putting extra money toward your mortgage may not make sense.

Essentially, fixed-rate mortgages are good for those who value (and want to pay for) rate stability over any potential short-term discount they might get by choosing an ARM.

How To Refinance Into An Adjustable-Rate Mortgage

The process of refinancing to an ARM is the same as other mortgage refinances. You’ll apply and get a credit check so the lender can verify your credit score and debt-to-income ratio. You’ll also share documentation like W-2s, 1099s, tax returns and pay stubs. Bank statements and statements from other accounts needed to qualify are also shared at this point.

Your home loan expert will run you through how ARM loans work, and answer any questions to make sure that an ARM is your best decision.

Finally, the key question to ask yourself during any refinance is whether it’s worth it. That’s going to depend on what your financial goals are for the refinance. You’ll also want to weigh the closing costs against the money you’re saving on a monthly basis and over the term of the loan.

The Bottom Line: When ARM Refinancing Makes Sense

An adjustable-rate mortgage has an interest rate that goes up or down after being fixed for a period of time at the beginning of the loan. The changes, which typically happen every 6 months or each year, are based on a market index added to a lender margin. There are limits on how much an interest rate can increase or decrease on an initial adjustment and each time after that along with a lifetime cap and floor.

ARMs can make financial sense if you’re a borrower with a larger loan or you’re planning to move before the adjustment ever happens. They are also used by some to take advantage of the low interest rate at the beginning of the loan as an opportunity to pay down the balance of their loan faster.

Whether to choose an ARM or a fixed rate also depends heavily on the market and the difference between the two interest rates. To fully go over your loan options, make sure you’re aware of today’s refinancing rates. If you’re ready to get started, you can apply online or give us a call at (888) 452-8179.