Should You Refinance To A Fixed-Rate From An ARM?

Peter Warden
Peter Warden
The Mortgage Reports Editor
June 14, 2017 - 5 min read

Is It Time To Get Out Of Your ARM?

Adjustable rate mortgages can save you a lot of money. And chances are that if you have had one for the last few years, it did make your home more affordable. But what about now? In a rising rate environment, should you get out of your ARM before rates increase?

Assumptions To Challenge

Here’s a quick Q&A for you:

Q. With an adjustable-rate mortgage, your monthly payments go up when the rate resets, right?
A. Sometimes. In recent years, many rates and payments actually fell when loans reset.

Q. And payments will spike sharply?
A. Probably not. Most loans have caps on adjustments.

Q. So should borrowers with ARMs be panicking right now?
A. Probably not. Here are four reasons to stay calm ...

1. ARM Loan with Fixed Rates

Nowadays, most ARMs are technically “hybrid adjustable rate mortgages.” That means they come with an initial period in which their rates are fixed. Only when that time expires can the rate float up or down.

That initial period is shown in your loan agreement, and is often three, five or seven years, though some are longer or shorter. If you’re two years into a five-year fixed period, you won’t be facing higher monthly payments for another 36 months.

Of course, if you’re 57 months into a five-year fixed-rate period, you could soon face higher payments. But that doesn’t mean it’s time to panic. Read on to discover why ...

2. Caps on Your ARM

Dig out your loan agreement, and there’s a very good chance you’ll discover up to three sorts of caps that limit the amount your rate (and therefore your payments) can rise.

These caps vary from mortgage to mortgage, so you need to do a bit of reading to find the protections yours provides.

Periodic Adjustment Caps

The first sort is intended to prevent sudden hikes that could be hard to absorb in your household budget. It sets a top limit (often two percent) on the amount by which your mortgage rate can rise each year.

You’ve probably seen these mortgages described as 3/1 ARMs, 5/1 ARMs, 7/1 ARMs and similar. The first number specifies the initial fixed-rate period in years, and the second shows (again in years) how often hikes are allowed after that. So a 5/1 ARM has five years fixed, and then permits annual rate increases.

Payment Caps

The second type of cap applies to your monthly payments rather than interest rates. It might, for example, say those monthly payments can’t rise at any one time by more than a certain amount.

Suppose that particular cap is set at 7.5 percent in your loan agreement, and you’re currently paying $1,000 a month. At most, you’d pay an extra $75 a month when your next hike is implemented.

Lifetime Caps

The third sort of cap limits even that. There’s a good chance your loan agreement specifies the amount by which your interest rate can rise in total over the lifetime of your loan.

Check your caps, and use The Mortgage Reports mortgage calculator to model how different rate increases might impact your payments.

These three types of cap together mean that even if interest rates suddenly soar, your exposure doesn’t. That doesn’t mean you won’t face some pain, but it’s probably less scary than you think.

3. Interest Rates Might Not Rise

Is it possible interest rates will suddenly soar? Of course. Is it likely? No.

Markets responded positively with the “Trump bump” to the presidential election result, largely because investors liked the new President’s policies on tax and deregulation.

However, some observers are already predicting a “Trump dump,” because investors might yet take fright over other policies, especially those concerning international trade and the deficit. There’s even talk of a “Trump slump,” meaning a recession.

Who’s right? Who knows? There certainly is a risk of the economy overheating, with too-high inflation forcing the Federal Reserve to hike interest rates aggressively. Former Fed chair Alan Greenspan warned about it in February 2017 when he spoke of 1970s-style rates, which peaked at around 20 percent.

However, Greenspan’s views are far from mainstream at the time of writing. And, if a Trump slump were to materialize, that could see interest rates tumbling again, perhaps to record or near-record lows.

Meanwhile, more soberly, the Federal Reserve, which is likely to have the biggest impact on your existing ARM rates, has said its forecasts imply small increases (probably 0.25 percent each) three times this year. And some commentators think even that number’s too high.


4. You Have Options

Most importantly, you don’t have to just sit back and take any pain rate hikes may inflict on your budget.

Assuming you have a reasonable credit score and some equity in your home, you likely have some attractive options, most obviously refinancing to a fixed rate mortgage (FRM) or a new ARM with a nice long initial period during which your rate will be fixed.

How Long Will You Likely Stay in Your Home?

The first question may be the most important. If your current home is your “forever home,” an FRM might be your best bet, because it gives you the certainty and security of knowing your first monthly payment will be the same as your last: You know, the one when you become mortgage-free.

But if you’re likely to move again anyway sometime in the next few years, it may not be worth paying the higher rates that typically come with FRMs.

So how likely is it you’ll move again to a new job? Perhaps to somewhere bigger to accommodate more kids or ageing parents? Or to a downsized home? Maybe to a smarter neighborhood? Or, heaven forbid, to a post-divorce home?

Few people can answer those questions with total certainty. But your best guess could save you paying too high a rate for either an FRM or a longer-than-necessary fixed-rate period on your new ARM.

Should You Refinance Now?

Of course, higher interest rates remain a real possibility, although you might think the likelihood of seriously higher ones currently looks remote.

And, if big hikes do materialize, there’s a good chance you’ll get some protection from caps on increases provided by your ARM agreement.

How much the prospect of increases in monthly payments bothers you will likely depend on how tight your current household budget is, and your personal tolerance for risk.

If you’re worried, by all means explore your options. But it’s probably too soon for you to panic about your ARM loan.

What Are Today’s Mortgage Rates?

Today’s ARM refinance rates depend on whether you refinance to another ARM or to a FRM. It also matters how much equity you have and what your FICO score is.