Refinance an Adjustable-Rate Mortgage?

Taking out an adjustable-rate mortgage (ARM) can be risky, but they can also be a great way of saving money. If you get your loan at a time when interest rates are low with a view to selling within a few years, there are definite advantages compared to a fixed-rate mortgage (FRM). If you get an ARM, you should always have the possibility of refinancing in the back of your mind—if interest rates begin rising it may end up being a necessity.

When you refinance, you take out a new mortgage and use the money to pay off the old one. There is very little difference between getting the initial mortgage and refinancing—the same requirements apply. You’ll need a good credit rating to refinance to a conventional mortgage, as well as steady income. It also pays to have some equity in your property, since getting a new mortgage means paying more closing costs, and possibly a prepayment penalty for paying off your ARM early. Depending on whether or not you have a prepayment penalty you can expect to pay 3-6% of your outstanding principal to refinance your ARM.

People usually refinance an ARM in favor of a fixed-rate mortgage for one of three reasons.

One of the most common of the three is simply that people underestimate how much more difficult it is to plan ahead and control cash flow when mortgage repayments are variable. It’s much easier to make long-term financial plans when you have a fixed monthly repayment.

Many people who get ARMs are only planning on short-term ownership of the property—they buy when the interest rate is low, and intend to sell up before rates increase. If they subsequently decide to keep the property long-term, switching to a FRM is a safer bet than relying on the ARM interest remaining low.

Lastly, some people who opt for an ARM do so because the interest rates are low, and they believe the rates will stay low. They may subsequently decide to refinance and get a FRM instead because they change their minds about the future of the market. If mortgage interest rates start rising and it seems like they may continue to rise, then refinancing is a wise move.

If you’re considering refinancing, there are three pieces of information you’ll need to help you decide whether or not it’s a good time to do it—your current ARM interest rate, the current fully-indexed rate on your mortgage, and the rates and terms of various FRMs currently on the market.

The fully-indexed rate is a combination of the interest rate index that your ARM uses and the margin on the loan. You can find both these figures on your note, and the current value of the index your mortgage uses can be found online in several places. To find out your current fully-indexed loan rate, add the current index value to the margin from your note. If the index doesn’t change, the fully-indexed rate is the rate that your ARM will be reset to at the next adjustment date. Compare your fully-indexed rate to current FRM rates to determine if refinancing is a good idea—if your current ARM interest rate and your fully indexed rate are higher than current FRM interest rates, then you’re good to go.