Refinancing gives you the option of choosing a different type loan than you already have. You can also refinance into the same type, if you so choose. Many homeowners toy with the idea of an ARM. In the past, most homeowners avoided this loan because of its fluctuating rates. However, there are certain homeowners who may benefit from this program.
The two most common types of homeowners benefiting from the adjustable rate mortgage are:
- Homeowners with jumbo loans
- Homeowners who need a lower payment for the time being
We will look at how these and other homeowners benefit. We will also explore how to know when and if the program is right for you.
How Does an ARM Work?
First, you must understand how the adjustable rate loan works. When you see this loan type advertised, you likely see it in numbers, such as 3/1. This means the interest rate is fixed for the first 3 years. It also means it adjusts one time per year. You may see adjustable rate mortgages with 3, 5, 7, and 10 year fixed rate terms. The longer you have a fixed rate, the higher the initial interest rate the lender charges.
When the interest rate adjusts, it does so according to its index. Most commonly, you will find loans tied to the LIBOR index or the Treasury Security index. While you cannot predict the adjusted interest rate, you can watch the coinciding index to see how it performs to help determine your future interest rate.
The Appeal of ARM Interest Rates
Borrowers who prefer an ARM loan do so because of the “teaser” interest rate. It is possible to save quite a bit of money during the introductory rate of the loan. With interest rates several points lower than standard fixed rates, you can save thousands of dollars. However, if you are still in the home when the rates adjust, you make up for those savings rather quickly.
Lenders also prefer adjustable rate loans because it brings them larger profits in the end. Even if borrowers refinance before the rate adjusts, the bank has the attention of the borrower. The borrower may refinance, but if he/she uses the same bank, the bank still profits. ARM loans are often held on the bank’s own portfolio, which allows them to be as aggressive or lenient as necessary.
Who Benefits from an ARM Refinance?
It makes sense that many people benefit from an ARM. The rates are lower, what’s not to love? However, because of the riskiness of the changing interest rate, there are certain people who benefit more than others.
- Homeowners who will move soon – If moving within the next 5 years is in your plans, an adjustable rate mortgage is a great idea. You can save money on interest while you live in the home and pay the loan off before the rate adjusts.
- Homeowners coming into money – If you know you have a windfall coming in the next few years enabling you to pay off your mortgage in full, the ARM may benefit you. Why pay more in interest if you do not need the stability of a fixed rate loan?
- Homeowners with a jumbo loan – Jumbo loans exceed $424,100. The loan payment on this loan amount is already rather high. Saving a few points in interest can really add up over the next few years.
Understanding the Risks of an Adjustable Rate Loan
Adjustable rate loans have several risks. The most obvious is the higher interest rate you may have to pay when the teaser rate expires. You cannot predict what will happen in 3, 5, or 7 years, so you have no idea what rate to expect. If rates adjust dramatically, you may not be able to afford the loan payment. This could put your home at risk for foreclosure. Luckily, you do have the option to try to refinance before the rate changes when the time gets closer.
However, if you have financial issues between the time you take the ARM and when it adjusts, you may be unable to refinance. If your credit score drops, debts increase, or your income stops, you may not be eligible for a refinance. This could leave you stuck with a very high interest rate that you cannot pay.
Choosing the Right Time
If you think you want an ARM, consider your circumstances. Is this your forever home? If so and you do not have any windfalls or capabilities of paying the loan off early, the adjustable rate is not the right choice. However, if you have plans to move, timing the refinance with your move can help you save money for your move. For example, if you know you will move in 4 years because of retirement or a scheduled job transfer, and you take a 5/1 ARM, you will pay the loan off well before it adjusts. This allows you to reap the savings of the lower interest rate during the next 4 years.
If you have a jumbo loan and want to save money for the time being, refinance. However, you must make sure you plan. If you will not move before the rate adjusts, plan accordingly. Make sure you keep your credit in good standing and keep your income flowing. Do not make drastic job changes or run up your debts so high that you cannot refinance. Securing an adjustable rate for the short-term is a good idea because of the thousands of dollars you can save in interest. However, you must be able to either afford the new payment or to refinance.
The right timing for an adjustable rate refinance depends on the current rates and your life situation. The best time is when you can secure an ARM term that coincides with your targeted moving date. If you need to save the money now regardless of moving, make sure you keep a careful eye on rates and your financial situation so you can turn things around if need be before the rate adjusts.