Sure, adjustable-rate mortgages (ARMs) are great during the low-rate introductory period. But what happens when the fixed rate expires and starts adjusting?
Higher monthly payments, that’s what.
That leaves borrowers in a bind: “Should I refinance or stay the course?” Fortunately, it’s pretty easy to decide what’s best for your particular circumstances.
Should I Refinance My ARM to a Fixed-Rate Mortgage?
Adjustable-rate mortgages come with their advantages, but they don’t make a great long-term solution.
Refinancing has its drawbacks too.
Which leaves you to decide between the lesser of two evils. You can choose between fluctuating interest rates and higher monthly payments, or thousands of dollars in fresh closing costs and possibly a longer debt horizon.
Benefits of Refinancing an ARM to a Fixed Rate
In nearly all cases, borrowers pay more when their initial interest rate expires and the adjustment period starts. But if interest rates are relatively low when the time comes, homeowners can often lower their monthly payment by refinancing to a fixed-interest mortgage, especially if they pay discount points.
Beyond lowering your monthly mortgage payment, you also gain the certainty that your payment will never, ever go up again. Your principal and interest remains fixed for the next 15 to 30 years, depending on the fixed term you select.
This means you can sleep at night knowing exactly what to budget for housing. A fixed mortgage rate also keeps your monthly budget more predictable, potentially letting you get away with a smaller emergency fund.
And in most cases, you won’t actually have to cough up cold hard cash for closing costs. Lenders typically roll these into the loan when you refinance. This raises your monthly payment a bit but won’t blow a hole in your pocket.
Drawbacks of Refinancing an ARM to a Fixed Rate
Refinancing has perks, but it isn’t all rainbows.
Just because you don’t have to cough up cash at closing doesn’t make the closing costs any less real. You still pay for them, and with interest — they add to your debt burden.
In many cases, refinancing not only adds to your total debt balance. It could also extend your debt horizon.
This is because many lenders push homeowners into fresh 30-year mortgage terms when they refinance. This means that instead of paying off your loan in however many years remain on your term, you sign a commitment to pay your mortgage for years longer than you would have otherwise.
If you don’t want to do this, you’ll have to push back when the lender suggests a 30-year term. And you’ll have to accept a higher monthly payment than you’d get on a 30-year term, though likely still lower than your new monthly payment would be when your adjustable-rate mortgage rate rises.
Either way, you start back at square one on your amortization schedule. At the beginning of your loan, a huge percentage of each monthly payment goes toward interest, and little goes toward paying down your principal balance. Over time, that ratio changes, with more of each payment going toward paying off your balance.
Which is precisely why mortgage lenders love to tempt you with juicy refinance offers when you get too far along in paying off your loan.
The Verdict: Should You Refinance an ARM to a Fixed-Rate Mortgage?
Should you refinance your ARM?
This depends on factors like how long you plan to stay at the property, whether you’re prioritizing paying off your mortgage early, your credit score, and your budget flexibility.
Only you know your financial plans and priorities, so use this rubric to help you decide.
You Should Refinance to a Fixed-Rate Mortgage If…
Refinancing is a good idea if:
- Your Rate Is About to Start Adjusting. If you still have some time left before your low introductory rate period expires, you don’t have the same urgency in your decision. But once your fixed-interest period ends, it makes sense to start options for lower interest rates.
- You Plan to Stay Long-Term. If you’ve found your forever home and never plan to leave, it often makes sense to refinance to a fixed interest rate. You have many years to recoup the one-time closing costs in the form of lower monthly payments.
- Your Credit Has Improved. When you first borrowed an ARM, it may have been the only affordable option if you had bad credit. If you’ve since improved your credit score, you can potentially score a great deal on a low-interest home loan, even compared to your ARM rate.
- Your Main Concern Is Monthly Cash Flow. Not everyone has much breathing room in their budget. If your personal finances are tight, or you might soon switch jobs and take a pay cut, you might not be able to stomach a variable monthly payment.
- You Want to Switch to a 15-Year Loan Term. If interest rates have dropped, and you’ve built some home equity by paying down your ARM loan early, you may be able to refi for a new loan with a 15-year term and a similar monthly payment.
You Should Keep Your Adjustable-Rate Mortgage If…
Refinancing an ARM to a fixed-rate loan doesn’t make sense if:
- You Plan to Sell Soon. If you’re planning on moving within the next year or two anyway, save yourself the thousands of dollars in closing costs and start planning your move instead.
- You Plan to Pay Off Your Loan Soon. Likewise, if you’re funneling extra money into paying off your mortgage early and plan to knock it out within the next few years, it often makes sense just to leave your loan in place. Check on whether your current loan charges a prepayment penalty before you plan on paying off your loan in a fixed period of time.
- Your Credit Has Tanked. If your credit score has dropped, you might end up paying just as much each month on a fixed-interest loan as you’re paying now on your ARM — if not more.
Final Word
When you refinance for a lower monthly payment, you pay for it with a one-time expense in closing costs. That means you can easily calculate the breakeven horizon: how long it will take you to recoup the up-front costs in monthly savings.
For example, if you pay $6,000 in closing costs, and you save $200 per month on your mortgage, it would take you 30 months to break even. In that case, it would hardly make sense to refinance if you plan on moving or paying off your loan within the next few years.
Try playing around with a mortgage refinance breakeven calculator to run the numbers for your personal scenario.
Finally, don’t try to time the market with interest rates. Either a refinance makes sense for you mathematically at current interest rates, or it doesn’t. If it does, lock in your mortgage rate now for a refinance, rather than crossing your fingers that interest rates will drop further.
