Should I refinance my ARM?

Over the past several years Adjustable Rate Mortgages (ARMs) have been a very popular option for homeowners. With rates climbing over the past two years, many customers are asking me if it is now time to lock in a fixed rate.

Many people had opted for hybrid ARMs. These programs offer lower fixed rate periods for the borrower at the beginning of the mortgage (usually the first 3, 5 or 7 years) and a yearly rate adjustment after that. Many people with the 3/1 ARM are already seeing their rates and payments adjust, and those with the 5/1 ARMs are losing sleep trying to anticipate how much their rates and payments will increase.

When you first chose your ARM, you were given disclosures that spelled out the adjustment caps. These caps tell you the MAXIMUM a rate can adjust at any given rate adjustment date.

There are typically three different adjustment caps:
1) the initial adjustment cap
2) the periodic adjustment cap
3) the lifetime adjustment cap

The initial adjustment cap lets you know the maximum your rate can adjust at the end of the fixed-rate period.

The periodic adjustment cap lets you know the maximum your rate can adjust at each rate change (usually monthly, bi-annually, or annually).

The lifetime adjustment cap lets you know the maximum the rate can change over the life of the loan. (If you have a 3/1 ARM, you may only notice two adjustment caps – this is because the initial and periodic adjustment caps are the same.)

In order to determine if you should refinance your ARM to a fixed rate loan, there are several things to consider. First, if your ARM has already adjusted, and the current rate is higher than the going fixed rate, you should consider refinancing. Your loan officer can let you know the costs and payments you will have and help you determine if it is the right move for you.

Second, if your mortgage is set to adjust in the near future, you have to find out what the margin is for your ARM. You can look at your closing documents to see what this is. Add the margin to the index for your ARM, and you will have the fully-indexed rate for your mortgage. At the next adjustment, your rate will move toward this rate, limited by your rate caps discussed above.
For example, if you have an ARM based on the 6 Month LIBOR index (5.370% as of 10/26/2006) and your margin is 2.75%, your fully-indexed rate is 8.124%. This is much higher than the current fixed rates and you should definitely consider refinancing.

Many people whose rates are not going to change for another year or so are hesitant to refinance. One of my customers has a 5/1 ARM at 4.5% that is set to adjust in January 2008. The index and margin on his loan are the same as in the above paragraph. He does not want to “lose” his 4.5% rate and take a fixed-rate between 6.0 & 6.5%.

At first, it seems that his strategy makes sense. But, most experts agree that rates will rise moderately from now until the beginning of 2008. So, if he waits until his ARM adjusts, and rates are higher than today, his new rate will be at least 8.125%. So, by “losing” the 4.5% for one year, he'll be saving a lot of money in future years, until rates fall to the levels we have seen in the recent past.

My advice is this: it never hurts to take a look at the costs and payments for a refinance. An experienced loan officer can give you all the information you need to make the decision to refinance or not. In most cases, now is the time to get out of the ARM and into a fixed-rate mortgage before rates climb any higher.

What are "points"?

Several people have written to ask about points.

Simply put, 'points' are fees the borrower pays the lender when the loan is closed. Each 'point' is equal to 1% of the loan. On a $100,000 loan, for example, 3 points would equal $3,000. When you pay points, you are paying interest up-front to lower the rate on your mortgage. Not all loans require you to pay points.

Some of you have asked if it is smarter to pay the points to get a lower payment on your mortgage. Typically, I recommend against paying points on a mortgage. There are severl reasons for this:

First, it usually takes about seven years before the amount you save on your mortgage payments equals the amount you paid in points. Most people will either sell their home and move or refinance their mortgage within seven years. In these cases, the money paid in points is gone and, in my opinion, wasted.

Second, you can usually save more on monthly payments by applying the money you would have spent on points to other higher-interest debt such as credit cards. The reduction of payments per month should be more than the reduction in your mortgage payment would be and, credit card interest is not tax-deductible whereas mortgage interest is.

Third, may people purchase a home and end up running up their credit card bills to furnish and decorate the home. By using the money that would otherwise go toward points, you can apply that to the furnishing and decorating and save on your credit cards.

There are some situations where it is advantageous to pay points. For instance, if the seller or builder are willing to pay points for you, take it. You get the lower payment and also get to deduct these points on your tax returns*.

All situations are different and there may be reasons to pay points. An experienced loan professional can show you the pros and cons of paying points or applying that money elswhere to better your financial position.

*Consult your tax advisor to see how this relates to you.