Is your adjustable-rate mortgage (ARM) about to adjust? You may not want to allow it. At current mortgage rates, today’s ARMs are resetting near 3.50%, which is the highest since 2012. Today’s adjusting ARM rates also end a 4-year streak, in which resetting ARMs garnered lower rates than “new” adjustable rate mortgage on the open market.
For the last decade, it’s paid to have a conventional adjustable rate mortgage, today, not so much. If you’ve been riding your ARM through its adjustments, you’ve benefitted from low rates. With market sentiment shifting, though, it’s time to consider a refinancing into something different, either a new ARM or a fixed-rate loan. ARMs are expected to adjust higher through most of 2016 and into 2017 as well.
An adjustable-rate mortgage is a mortgage for which the interest rate can change (i.e. adjust) over time based on “market conditions”. Sometimes, ARM mortgage rates adjust higher. Sometimes, ARM mortgage rates adjust lower. And, ARMs can be an excellent option for first-time homebuyers.
However, ARM interest rates fluctuate for the homeowners who use them, ARMs carries a financial risk not present with fixed-rate loans. For example, when you use an ARM to finance your home, there is no way to know what your mortgage rate will be in 10 years. Uncertainty can be frightening. It can be hugely rewarding, too. Consider this: since 2003, nearly every U.S homeowner using a conventional ARM home loan “beat the bank” on their mortgage. This is because, between 2003 and late-2015, adjustable-rate mortgages adjusted below the rates you could get on a “brand-new” loan (and with no closing costs required!).
That streak ended in December 2015, though, when the Federal Reserve raised the Fed Funds Rate from its target range near zero. When the Fed raises the Fed Funds Rate, it can affect the drivers for an adjusting ARM.
As a quick refresher, here’s how adjustable-rate mortgages work.
- For a fixed period of time, usually 5 or 7 years, your mortgage rate is constant
- When the fixed period ends, your rate adjusts according to a preset formula
- Once annually thereafter, your rate adjusts using the same preset formula
The preset formula is a simple one. The new rate for the adjustable-rate mortgage is the sum of some variable market rate, typically the 12-month LIBOR, and a pre-determined constant, which is typically 2.25 percent. Adding the constant and the variable shows your new rate. Today, that sum is (2.25) + (1.17), or 3.42%. 3.42% is a low mortgage rate, but it’s higher than what you could get for a new 5-year ARM from an approved mortgage lender. According to Freddie Mac, new 5-year ARMs average 3.09 percent nationwide.
However, with a new ARM, there are closing costs to pay. For example, in order to lock the 3.09% 5-year ARM rate shown by Freddie Mac, borrowers are expected to pay 0.5 discount points to the lender. And, closing costs apply, too.
If you prefer to let your loan adjust, you won’t get access to the 3.09% rate, but you won’t be responsible for closing costs, either. This is because, with an adjusting loan, there are no appraisals, no verifications of your income, and no credit check required.
In addition, an adjusting loan requires no underwriting and no fees paid to title companies. You’re not even required to have a job. So, there are reasons to refinance away from your adjusting ARM, but allowing an adjustment can make sense to your cash flow, too.
If your current loan is an adjustable rate mortgage and the loan is about to adjust, you have a decision to made as a homeowner, should I let my ARM adjust or should I refinance it?
In all, there are three options for your adjusting ARM:
- Do nothing. Let your loan adjust; revisit mortgage rates again next year
- Refinance your ARM to a new ARM at today’s ARM mortgage rates
- Refinance your ARM to a new fixed rate loan at today’s fixed rate pricing
Each option has merits.
If you allow your adjustable rate mortgage to adjust (Option 1), your lender will assign a new mortgage rate based on today’s LIBOR. Most homeowners will get a rate near 3.42%, which will be assigned for the 12 months. The payment on a 3.42% mortgage rate is $445 for every $100,000 owed.
You can also refinance your adjustable rate mortgage into new adjustable-rate loan. Via a new ARM, you can lock your rate for the next 5 or 7 years or longer, depending on your needs. You’ll postpone the adjustments of a recasting ARM and, according to Freddie Mac’s most recent mortgage rate survey, will get an average rate of 3.09% for a 5-year ARM for an accompanying, one-time fee of 0.5 discount points. The payment on a new ARM is $426 per $100,000, which saves $19 monthly but which is also subject to closing costs which could add up to the thousands, depending on in which state you live. Lastly, you have the option of switching your ARM into a fixed-rate loan.
This is the most common way homeowners remove the uncertainty of “changing mortgage rates” and, according to quarterly refinance reports from the government, 66% of homeowners with ARMs make this choice.
Refinancing your ARM into a fixed-rate loan can be a good fit for several reasons, especially if you expect that the economy will improve this year or next, and you plan to stay in your home for a few more years.
An improving economy moves LIBOR rates higher and LIBOR is the basis for your adjusted ARM mortgage rate. With a fixed-rate mortgage, you’ll get a stable monthly because your interest rate is fixed and so is your payment.
The downside is that fixed-rate mortgages are roughly 100 basis points (1.00%) higher than comparable ARM mortgage rates, which means that your “stable payment” might be higher than your adjusted one.
For U.S. homeowners with adjusting adjustable rate mortgage, the best “refinance move” may be to skip the refinance entirely. You’ll have to compare mortgage rates and see what’s best for you.
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