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 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 you pay remains constant throughout your loan term. Your mortgage payment on a fixed-rate only changes with updates in escrow like the removal of mortgage insurance, changes in property taxes or homeowners insurance premiums.
It could be very easy to confuse an ARM with a variable-rate mortgage. However, a traditional variable-rate mortgage can have an updated interest rate every month. ARMs don’t work that way. Variable-rate mortgages aren’t very common. So how do ARMs actually 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 an index added to a lender margin.
The most common index for conventional loans is the 30-day average of the Secured Overnight Financing Rate. Government-backed loans from the FHA or VA are based on the Constant Maturity Treasury.
The fixed-rate at the beginning of the loan is often called a teaser rate because it’s lower than the existing fixed rates you can get on the market at the time. The rate can be lower because mortgage investors don’t have to predict inflation as far in advance, knowing the rate can change in the future.
Once the fixed-rate period is over, the rate can adjust up or down periodically according to the terms of the mortgage. There are caps and floors in place within your mortgage agreement. These stipulate that 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.
ARMs typically feature 30-year terms. If and when your interest rate adjusts, your loan is re-amortized over the remainder of your term. That’s finance jargon for the payment adjusting so that the remaining balance is paid off by the end of your loan term assuming the new interest rate stays constant for the rest of your loan. This process is repeated each time your rate adjusts.
At this point, an example is probably best to show exactly how this works. Let’s say you have a $300,000 loan with a 5-year ARM that adjusts every year thereafter at an initial interest rate of 3%. 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. If it adjusts every 6 months instead of once per year, the 1 would be replaced with a 6.
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. Make sure you also 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 is typically 10 years.
- You really 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. This has the effect that by the time your rate adjusts, or you refinance, you’ll have a much lower payment even if you haven’t paid it off because your balance will be smaller.
- 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 part of the loan.
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.
- 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. However, if you make only your scheduled payments under an ARM, you could pay for it in the future by having a significant balance if the rate goes up.
Essentially, fixed-rate mortgages are good for those who value rate stability over any potential short-term discount they might get by choosing an ARM.
The Process For Refinancing To An ARM
Motivations for financing into an ARM are going to be the same as they would be for any other mortgage. You could be looking to save money on your payment or shorten your term to pay off your mortgage faster. Finally, you could be refinancing to cash out existing equity.
Similarly, the process is going to be the same. You’ll apply and get a credit check so the lender can take a look at 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 that you want to use to qualify are also shared at this point.
You’ll have the option of choosing an ARM. Your Home Loan Expert should run you through how ARM loans work, but if you have any questions, now is the time to ask.
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 in 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: An ARM May Be A Viable Refinancing Option
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 an 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 sense if 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. On the other hand, if you plan to stay in your home long-term and stick to the scheduled payment, a fixed-rate option may be better.
Whether to choose an ARM or a fixed rate also depends heavily on the market and the spread between the two interest rates. To fully go over your 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) 452-0335.