Not many homeowners take out an adjustable-rate mortgage when they buy a home, but the mortgage type is making a comeback as interest rates continue to climb. According to data from CoreLogic, a mortgage data and analytics company, ARMs made up about 10% of new mortgages of between $400,001 and $1 million in March 2022. That's up from 5% the year before.
While this type of mortgage loan is appealing to homebuyers hoping to save some money upfront, it can cost more in the long run if they're not careful.
If you have an ARM or you're thinking about getting one, you may want to consider refinancing it into a fixed-rate mortgage in the future. Here's why and when to think about doing it.
Read:Best Adjustable-Rate Mortgage Lenders. ]
Why Are ARMs Attractive?
With a fixed-rate mortgage, your interest rate remains the same for the life of your loan. This predictability and simplicity make it the more popular type of mortgage rate by far.
With an ARM, your interest rate remains fixed for a certain period – typically three, five or 10 years – after which it switches to a variable rate that adjusts every six or 12 months. These are called hybrid ARMs. There are also other types of ARMs, like interest-only ARMs and payment-option ARMs. What all ARMs have in common is an initial fixed-rate period and then a longer adjustable-rate period.
That arrangement shifts the risk of rising interest rates from the lender to the borrower. But for some homeowners, that risk is worth it for a few reasons:
Lower Upfront Interest Rates
ARMs offer lower interest rates during their fixed period than fixed-rate mortgages. As of June 16, 2022, Freddie Mac pegs the average rate for a 5/1 ARM – that is, a loan that offers a five-year fixed period, after which the rate adjusts once a year for the remaining 25 years – at 4.33%. If you were to opt for a 30-year fixed-rate mortgage, the average rate is 5.78%.
On a $400,000 mortgage loan, the adjustable-rate option would save you $355 per month, or $21,300 over five years.
"ARMs are a great mortgage product in a rising rate environment," says Deb Klein, branch manager at Reliability in Lending at Primary Residential Mortgage. "It creates the ability for families and individuals to afford the homes and neighborhoods they want to live in without greatly impacting the quality of life and style of living they are accustomed to."
Qualification Is Easier
ARMs are less risky for lenders than fixed-rate mortgages because if interest rates increase, lenders can capitalize by increasing your rate after the fixed period.
As a result, it's generally easier to qualify for an ARM than a fixed-rate mortgage. If your credit history is less than stellar, you don't have a large down payment or your debt-to-income ratio is relatively high, an adjustable-rate option may be more appealing to you.
If you're not certain about your future, the fixed period on an ARM may be short enough to give you the flexibility you need.
For example, a lot can happen in five years. If you choose to move or if interest rates go down, you can enjoy the lower rate and monthly payments and still have the option to refinance or sell before the less predictable adjustable-rate period begins.
This is especially true if you plan to stay in the home for less time than the fixed period of the loan.
Can You Refinance an ARM to a Fixed Mortgage?
ARMs may be appealing upfront, but "the glitz of lower payments can suddenly lose its glamor after the grace period ends and a new period of higher payments begins," says Jodi Hall, president of Nationwide Mortgage Bankers.
Homeowners can refinance their ARM to a fixed-rate mortgage at any time. In the right scenario, you could secure an interest rate that's about the same or even lower than what you're currently paying.
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Read:Best Mortgage Refinance Lenders. ]
"Refinancing into an FRM provides stability in the form of fixed expenses, which allows individuals to feel more secure with changes in personal planning, such as retirement," says Klein.
Even if your new rate is slightly higher, refinancing to a fixed-rate mortgage will be less risky in the long run. But depending on the situation, there are some potential downsides to consider:
Every time you take out a new mortgage, whether it's a purchase loan or a refinance loan, you'll need to pay closing costs, which can amount to 2% to 6% of the loan amount. In many cases, you can either pay those costs upfront or roll them into the new loan.
Rolling them into the new loan may sound like a good idea, especially if you don't have a lot of cash on hand. But over 30 years, $10,000 in closing costs with a 5% interest rate will end up costing you $19,326.
Interest Rate Risk
While you may have gotten an ARM with the plan to refinance before your fixed period is up, an ARM refinance may increase your costs if interest rates have increased since you first took out the loan.
If rates have gone up drastically, it could even make your new loan unaffordable, at which point you may feel forced to hold onto the ARM.
The silver lining in this scenario is that lenders limit how much they can hike an interest rate (during each adjustment period and overall), so you may not immediately have to pay the current market rate. Still, it gives you less flexibility and can make you feel helpless about your situation.
Some ARMs may come with a prepayment penalty, which kicks in if you refinance your loan or sell your home within three to five years. The penalty may be a fixed amount – such as six months' worth of interest – or a percentage of your principal balance.
This fee, which can cost thousands of dollars, will be in addition to your closing costs on the new loan. So, if you're planning on applying for an ARM, watch out for such a penalty. And if you're thinking about refinancing, review your loan agreement for it.
Read:Best Mortgage Lenders. ]
When Is the Right Time to Refinance an Adjustable-Rate Mortgage?
As with any major financial decision, it's important to consider both the benefits and the drawbacks. With that in mind, here are some situations where it might make sense to refinance your ARM:
- Your credit score is in good shape. If your credit score is as good or better than it was when you first took out the loan, you'll have a better chance of getting a comparable (or even lower) interest rate to what you're paying right now. And in a rising interest rate environment where there's little possibility of getting a comparable or lower interest rate, it can still help you maximize your savings on the new loan.
- You're planning on staying in the home for a long time. If you're nearing the end of your fixed period and you're only planning on staying in the home for another one or two years, the closing costs on a refinance may outweigh the potential increase in your monthly payment if your rate adjusts upward. On the flip side, if you're not planning on moving within the next few years, it may be worth it to lock in a fixed interest rate, especially if current and future economic conditions appear murky.
- You can afford the closing costs. It's generally better to pay closing costs out of pocket than to roll them into the new loan. If you can afford that without putting your emergency fund at risk, and you plan on staying in the home for several years, it may be worth it.
- You have other financial goals. If you're thinking about doing a cash-out refinance to consolidate debt, pay for home renovations or achieve other financial goals, switching to a fixed interest rate at the same time allows you to accomplish two goals at once.
- Interest rates are expected to increase dramatically. If interest rates are already on the rise, you may want to lock in a fixed rate earlier rather than later. That's the case even if you're not nearing the end of your fixed period. Do some research on the direction interest rates are going and what experts are saying about their trajectory to make a decision.
- You're ready for more security. Even if interest rates are increasing, the long-term future of the market is unpredictable. "If rates fall in the future, you will have refinanced for nothing," says Hall, "but if they rise, you may have saved yourself tens of thousands of dollars." If you'd rather have the predictability of a fixed monthly payment instead of the potential for a lower payment in the future, refinancing can give you that peace of mind.