Interest rates are on the move and many homeowners are thinking about refinancing their mortgages. When interest rates go down, people often refinance to save money on interest or reduce their monthly payments. Another reason people think about refinancing is to switch from an adjustable rate mortgage (or "ARM") to a fixed rate mortgage. Let’s look at the advantages and disadvantages of this type of refinance.
Differences between an adjustable rate mortgage (ARM) and a fixed rate mortgage
An adjustable-rate mortgage is a mortgage where the interest rate varies throughout the life of the loan. Many ARMs have an introductory rate that is set for a period of time and then may change. One popular adjustable rate mortgage is the 5/1 ARM which means the interest rate stays the same for the first five years of the loan and afterwards may adjust once a year. With a fixed rate mortgage, the interest rate stays the same throughout the life of the loan.
Some people choose adjustable rate mortgages because the starting interest rate can be lower than the interest rate on fixed rate mortgages. People who are planning to own a house for a shorter period of time may also choose an ARM to take advantage of the lower interest rate. For example, people who are planning to own a home for five years might choose a 5/1 ARM because they plan to sell the house before their interest rate adjusts.
Predictable payments. An advantage of refinancing to a fixed rate
Many people refinance from an adjustable rate to a fixed rate mortgage because they want their payments to be more predictable. With an ARM, the amount of money you pay in interest each month can change. With a fixed rate, the amount you pay in interest will always stay the same. Many homeowners value the peace of mind that comes with knowing their interest payments won’t change.
Keep in mind that your monthly mortgage payment includes escrow payments for your property taxes, homeowners insurance, and private mortgage insurance (PMI) if your loan requires it. Your escrow payments can change whether you have an adjustable rate or a fixed rate mortgage, which can change your total monthly payment too.
Does refinancing to a fixed-rate mortgage save money?
That depends on many things, including the terms of your current loan, what happens to interest rates, and how long you plan to live in your home. Many homeowners refinance to a fixed rate mortgage when rates are low so they can "lock in" savings on interest payments. These homeowners may believe that interest rates are likely to rise in the future, and refinancing to a fixed rate mortgage will protect them from paying more down the road.
Keep in mind that when you refinance, you may need to pay new closing costs to get a new mortgage. Financial professionals recommend you balance the closing costs of a refinance against the savings a new loan might offer. Many times they will recommend you calculate a "break even" point, that is the moment when the cost of refinancing is balanced by the savings.
Say for example you refinance your mortgage, pay $1,200 in closing costs, and save $100 a month. In this case, you will break even after one year. Starting in the second year of the new loan, you will save $100 a month and the longer you live in the house the more you will save. This is the reason why financial professionals often recommend you refinance when you are confident you will continue to live in your house for some time.
Does keeping an adjustable-rate mortgage save money?
In the example above, most of the savings of refinancing from an adjustable rate to a fixed rate mortgage are based on the guess that interest rates will rise. That is, the homeowner is refinancing at the moment when the homeowner believes interest rates have reached a low and may soon go higher. What interest rates will actually do in the future is hard to predict, however. And this makes it hard to know if refinancing or keeping an adjustable rate mortgage is a better bet.
One of the advantages of an adjustable rate mortgage is that it can reduce your interest payments when interest rates decline. You might get some of the benefits of refinancing without having to complete any paperwork or pay any closing costs. And if interest rates hold steady or decline further, you might continue to save money from future adjustments.
Another question to consider before you refinance is the length of your new loan. There are two main factors that affect how much money you will pay in interest over the life of a loan. The first is the size of your monthly interest payment. The second is how many years you are paying these monthly interest costs. If you refinance from an old mortgage that has 25 years left to a new 30 year fixed-rate mortgage, you may take longer to pay off the new loan. And pay more money in interest as a result.
Ask Freedom Mortgage about refinancing from an ARM to a fixed-rate mortgage
The decision to refinance from an ARM to a fixed-rate mortgage can be a little complicated. Would you like to learn more about whether refinancing makes sense for you? Please ask one of our friendly and knowledgeable Loan Advisors. We will be happy to help! Visit our Get Started page or call us at 877-220-5533.