One of the interesting features of the current mortgage scene is that some borrowers with adjustable-rate mortgages (ARMs) are refinancing into fixed-rate mortgages (FRMs), and some with FRMs are refinancing into ARMs.
My exchanges with borrowers on both sides of this divide indicate that differences in opinion on where interest rates are headed have little bearing on their plans. The major difference between the groups is their expectations about how long they will have their mortgage.
I wrote about borrowers refinancing out of ARMs into FRMs last year. These borrowers generally expect to have their mortgages a long time. For this reason, they are willing to pay the higher rate on an FRM now in order to avoid the risk of an even higher rate in the future if they retain their ARM.
While many of them look to delay the decision (and retain their low-rate ARM) as long as possible, they also fear that if they wait too long, the market might change so quickly that the refinance option will be lost. That’s why I entitled my article "Low-Rate ARMs and High Anxiety."
Borrowers looking to refinance out of FRMs into ARMs generally expect to be out of their houses before the first rate adjustment on a new ARM. Their logic is that the low initial rate on the ARM will save them money, and they will be gone before any future rate increases take effect. These borrowers want to refinance as soon as possible because every month of delay is a month of lost savings. This article is about them.
Where the first group faces the risk of losing the refinance opportunity if they wait too long, this group faces the risk that something will happen to upend their plan to sell their house and pay off the mortgage. Life has a bad habit of not always going according to plan. It is prudent to prepare for this contingency.
The best way to do this, and in most cases a relatively painless way, is for the borrower refinancing into an ARM to continue to make the larger FRM payment. This accelerates reduction in the loan balance, so that if the borrower still has the mortgage when the ARM rate adjusts, any payment increase will be smaller.
Here is an example. The borrower currently has a 30-year FRM with a balance of $100,000, a rate of 4.75 percent and a payment of $522. He refinances into a 5/1 ARM on which the rate is fixed at 3.25 percent for five years. His payment on the ARM is only $435.
If he still has the mortgage after five years, assuming a worst-case escalation of interest rates during the period, the new rate will be the ARM maximum of 8.25 percent and the new payment will be $704 — a 62 percent increase.
But suppose instead of making the lower ARM payment, the borrower continues to make the FRM payment of $522. In that event, the rate increase to 8.25 percent in month 61 will cause the payment to increase from $522 to $660 — a more manageable 26 percent. On a stable rate scenario — assuming rates don’t change over the five years — the larger payment will result in a complete payoff in 267 months.
The benefit of the larger payment scales up with the FRM rate. I used 4.75 percent because that was the market rate on the 30-year FRM on the same day that the 5/1 ARM rate was 3.25 percent. But borrowers looking to refinance into an ARM will have varying rates on their FRMs, depending on when they were originated.
For example, if the FRM rate was 6 percent instead of 4.75 percent, the payment would be $600 instead of $522. In the worst case where the ARM rate jumps to 8.25 percent after five years, the payment increase would be only 3 percent to $620. In the event that rates don’t change at all, the ARM would pay off in 220 months.
The bottom line for borrowers with FRMs who expect to be out of their house within the next seven years or so: The higher the FRM rate they are now paying relative to the ARM rate they can command in the current market, the stronger the case for refinancing into a low-rate ARM while continuing to make the higher FRM payment.