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When fixed-rate mortgage rates start dipping, it might be a good idea to consider refinancing your fixed-rate loan into an adjustable rate mortgage with lower interest during the introductory period.
ARMs can be a good choice if you want the lowest rate initially (though the rate likely will increase later) or if you plan to sell in a couple of years before the rates adjust. But the rate adjustments might not be the best idea if your income fluctuates, for example.
Here’s what you should know about refinancing into an ARM (and whether or not you should):
Refinancing into an adjustable rate mortgage (ARM)
While a fixed-rate mortgage has the same interest rate and payment amount for the life of the loan, an ARM’s interest rate and payment amount change periodically.
So while the rate during the initial fixed period is typically lower than a fixed rate loan, the rate can fluctuate after the initial period is over.
So a 5/1 ARM is a loan that initially has a fixed rate for five years, followed by a rate change once a year.
There are many different types of ARMs, though, not all are available through Credible Operations, Inc. Some include ARMs with an interest-only period and payment-option ARMs that offer the flexibility to pay just interest or both interest and principal. Other types are named for the frequency with which the interest rate adjusts (5/1, 7/1, etc.).
When you should refinance into an ARM
ARMs aren’t for everyone, but they make sense for some homeowners who are considering refinancing their homes. These circumstances can make an ARM work in your favor, but keep in mind that each ARM product is different:
You want the lowest interest rate today
ARMs typically have lower rates than fixed-rate loans — at least for the initial period. When paying the lowest possible interest in the first few years is the goal, an ARM could be the way to go.
You’re planning to sell your home in the next several years
It’s worth considering refinancing into an ARM if you’re planning to sell your home. In this case, you’d select a loan with an adjustment period matched to your target sale date to avoid the interest reset and any corresponding payment increase.
Tip: You might consider a 7/1 or 5/1 ARM refinance to coincide with a milestone like retirement or a child’s graduation that might trigger you moving — or a 3/1 if you’re planning to relocate soon.
You expect your income to increase
The lower rate you’re likely to pay during the initial period with an ARM can ease financial pressures and buy you some time when you’re expecting your income to increase.
Lower payments will make life easier now, and the extra income will keep the loan affordable in the event your interest rate increases after the loan adjusts.
You think interest rates are on the decline
Your fixed-rate loan saves you money when interest rates are on the rise, but it doesn’t let you take advantage of declining rates. But an ARM can. As long as the rate goes down when it’s time for your loan to adjust, so might your payment.
It can be very hard to predict what future interest rates will be, so this shouldn’t be a primary reason for refinancing into an ARM.
When you shouldn’t refinance into an ARM
Refinancing into an ARM can have devastating consequences for your finances if you’re not careful. These situations make an adjustable rate a little more risky:
Your income is unpredictable
There’s no telling which way interest rates will go over the long term. If they go up, so might your payment, which can be especially difficult for the self-employed and others whose income fluctuates.
Also, if you’re on a fixed income that will most likely not be increasing, an ARM might not be a good idea. This is because you might not be able to handle the rate or payment increases after the introductory period is over.
You plan to pay off your mortgage early
Assuming your loan allows prepayment, it is possible to pay off an ARM early. But it’s more complicated than with a fixed-rate loan.
Extra principal payments on a fixed-rate mortgage don’t affect the payments, but they do reduce the term of the loan.
An ARM, on the other hand, essentially recasts every time the rate adjusts, spreading the remaining principal out over the remaining term of the loan. So unless your extra principal payments outpace the rate increases, you’re unlikely to shave more than a few months off the term of your loan with an ARM.
The interest savings aren’t worth it
The cost of refinancing can offset any savings you stand to gain by reducing your interest rate and your payment temporarily.
Closing costs like the application and origination fees, appraisal, title search, and title insurance can add as much as 5% to the amount you’re refinancing.
In this scenario, you’d only reduce your monthly payment by about $5 during the five year initial fixed interest rate period of your loan, after which the rate and payment will begin to vary, which is probably not enough to warrant adding to your debt.
Why ARM rates are lower than fixed rates
After the initial teaser period, ARM rates are based on two factors:
- Index rate: A rate based on market conditions
- Margin: The amount the lender tacks onto the index rate
If you add these two together, you’ll get the fully indexed rate, which is the standard rate borrowers would pay today if the lenders did not offer promotional rates.
Lenders discount the fully indexed rate to offer a lower promotional rate during the initial period. This starts you out with an artificially low rate that can increase substantially once it resets.
Here’s an example of ARM introductory rates — and corresponding introductory payments — for a $150,000 refinance loan compared to fixed rates:
| Loan type | Term | Rate | Payment |
|---|---|---|---|
| 30-year fixed | 30 years | 4.50% | $760 |
| 20-year fixed | 20 years | 3.99% | $908 |
| 15-year fixed | 15 years | 3.50% | $1,072 |
| 7/1 ARM | 30 years | 2.85% | $620 |
| 5/1 ARM | 30 years | 3.00% | $632 |
| Note: All numbers here are for demonstrative purposes only and do not represent an advertisement for available terms. | |||
How to quality for an ARM refinance
Applying for your ARM refinance probably won’t be much different than applying for your current loan except that an ARM can be easier to qualify for, especially if you have other debt.
Ideally, you’ll have at least 20% equity in your home before you refinance. Although you can borrow up to 95% of your home’s value, you’ll have to pay private mortgage insurance until your loan-to-value ratio is scheduled to drop below 80%.
After that point, you can request PMI cancellation. PMI costs an average of 0.05% to 1% of your loan amount per year.
Bottom line when refinancing to an ARM
More often than not, homeowners looking to refinance want to know how to refinance an ARM into a fixed-rate loan. But there are good reasons to consider a fixed-rate to ARM refinance.
For the right borrower, refinancing to an adjustable rate mortgage can be a great way to reduce your mortgage payment and rate for several years. But make sure to do what’s right for your situation: Interest rate adjustments over the course of the loan can leave you with higher payments in the end that you’re not prepared for.
If you’re considering refinancing your mortgage into an ARM or otherwise, Credible can do a lot of the legwork for you, so you don’t have to feel lost or overwhelmed. You can compare rates from multiple lenders in just minutes with no obligation to choose one unless you’re ready.
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