Is refinancing from an ARM to a fixed-rate mortgage right for you? Refinancing allows people with adjustable rate mortgages (ARMs) to convert to fixed-rate loans, an advantage even if they don’t save on their monthly payment immediately.
An ARM or variable interest rate can rise based on market or index rates while the interest rate of a fixed-rate mortgage does not change during the length of the loan term. ARMs have an initial fixed- rate period, when rates and monthly payments are lower than fixed-rate loans. When the fixed-rate period ends, the monthly payment adjusts based on the type of loan you have. Your interest rate (and monthly payment) will rise or fall based on the market rate or index.
Refinancing out of an ARM to a fixed-rate mortgage may provide:
Stability. You may gain protection from rising interest rates and future payment increases. Fixed-rate loans provide the security of predictable monthly payments.
Securing a Lower Interest Rate
One of the best reasons to refinance is to lower the interest rate on your existing loan. Historically, the rule of thumb was that it was worth the money to refinance if you could reduce your interest rate by at least 2%. Today, many lenders say 1% savings is enough of an incentive to refinance.
Reducing your interest rate not only helps you save money, but it increases the rate at which you build equity in your home, and it can decrease the size of your monthly payment. For example, a 30-year fixed-rate mortgage with an interest rate of 9% on a $100,000 home has a principal and interest payment of $804.62. That same loan at 6% reduces your payment to $599.55.
When interest rates fall, homeowners often have the opportunity to refinance an existing loan for another loan that, without much change in the monthly payment, has a shorter term. For that 30-year fixed-rate mortgage on a $100,000 home, refinancing from 9% to $5.5% cuts the term in half to 15 years, with only a slight change in the monthly payment from $804.62 to $817.08.
To figure out whether refinancing with a loan term extension will help you save, do two calculations: one where the new loan has the same term as the old loan, and one where the new loan is the length of your planned refinance. Compare the interest savings to see if refinancing accomplishes your financial goal.
Some people refinance simply to make the monthly mortgage payment more affordable. A lower interest rate and/or a longer loan term both work toward lowering the monthly payment. As long as the homeowners understand they may not be minimizing total interest expense, affordability can be a motivation for extending the loan term.
While short-term savings are important, they are not the only factor to weigh when considering a refinance. Refinancing to get out of an ARM, piggyback mortgage, interest-only mortgage or other onerous mortgage provisions may be reason enough to take on a refinancing.
However, in some cases, homeowners with ARMs would be fine sticking with their loan, especially if they don’t plan on being in the loan long term and the reset rate on their mortgage isn’t financially threatening.
Converting Between Adjustable-Rate and Fixed-Rate Mortgages
While ARMs start out offering lower rates than fixed-rate mortgages, periodic adjustments often result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to a fixed-rate mortgage results in a lower interest rate as well as eliminates concern over future interest rate hikes.
Conversely, converting from a fixed-rate loan to an ARM can also be a sound financial strategy, particularly in a falling interest rate environment. If rates continue to fall, the periodic rate adjustments on an ARM result in decreasing rates and smaller monthly mortgage payments, eliminating the need to refinance every time rates drop. Converting to an ARM may be a good idea especially for homeowners who don’t plan to stay in their home for more than a few years. If interest rates are falling, these homeowners can reduce their loan’s interest rate and monthly payment, but they won’t have to worry about interest rates rising in the future.
Like many homebuyers, you may have been attracted to the low initial interest rate of an adjustable-rate mortgage (ARM). While adjustable-rate mortgages have lower initial interest rates than fixed-rate mortgages, the lower interest rate is only for a set period of time.
If you obtain a mortgage to convert to a fixed rate you will repay more than you borrowed. In addition to your interest rate, term and loan amount, how much you repay is determined by several factors. Here are the components you need to know:
Interest Rate
The interest rate is the percentage of your loan amount we charge you to borrow money.
Interest rates are based on current market conditions, your credit score, down payment, and the type of mortgage you choose. Check today’s rates.
Discount points
One point equals 1% of your mortgage amount.
If you qualify, you may be able to pay one or more points to lower your interest rate. A lower interest rate means lower monthly mortgage payments.
You may be able to finance points as part of your mortgage amount.
Points are usually tax deductible. (Consult a tax advisor on the deductibility of discount points.)
Origination charge
The amount that includes all charges (other than discount points) that all loan originators (lenders and brokers) involved will receive for originating the loan.
This charge covers items including fees, document preparation, and underwriting costs, and other expenses.
If you qualify, you may be able to finance the origination charge as part of your mortgage amount.
Loan term
Your loan term is the amount of time you have to pay off your mortgage balance.
Shorter loan terms typically mean higher monthly mortgage payments, but often have lower interest rates. And if you pay off your mortgage balance within a shorter term, you may pay less in total interest than with a longer-term mortgage.