Should I Refinance into a Fixed Rate Mortgage or Adjustable Rate Mortgage?
With the lowest mortgage rates we have seen in years, many home owners are refinancing to cut their mortgage payments. This page provides advice on whether to choose from a low fixed rate mortgage or an even lower adjustable rate mortgage for borrowers with conforming loan amounts of below $417,000 for single family properties. For an analysis of fixed versus adjustable rate options for jumbo loans, click here.
30-Year Fixed Rate Mortgage
A 30 year fixed rate mortgage provides absolute certainty that your monthly mortgage payment of principal and interest will never change. Borrowers also have the certainty that if they keep their loan for 30 years, their loan at the end of that time period will be paid in full. Rates for fixed rate mortgages in 2009 have been running from the mid to high 4% range up to the low 5% range depending on your credit score, your loan-to-value and several other underwriting factors (to see what your exact rate would be for a fixed rate loan, submit a rate quote request here.
Adjustable Rate Mortgages (ARMs)
The interest rate on adjustable rate mortgages (ARMs) can change so borrowers may get an initial low rate but could see much higher rates in later years. In 2009, most ARMs available from lenders have an initial interest rate that is fixed for either three, five or seven years (called a 3/1 ARM, 5/1 ARM or 7/1 ARM). The start rates on these ARMS have actually gotten into the high 3% range which becomes very tempting.
Case Study: A Refinancing Scenario
The following refinance example can help show you whether a fixed or ARM rate is best for your specific financial goals is an example. For a $300,000 refinance, the recent rates for a 30 year fixed was 4.75% with two points and the rate for a 5/1 ARM (where the rate is fixed for five years and then adjusts annually after that) was 3.50% with two points. For the first five years, the fixed rate payment would be $1,565 per month while the ARM payment would be $1,347 per month.
The best way to judge whether an ARM is appropriate for your current financing needs is to look at the worst case scenario and see how long you could handle it. In the above example, that low rate ARM would be great if you truly anticipate holding your home for less than five years. But if you still have your home when the rate on your ARM can start to change, that low 3.5% rate could in years six, seven and eight increase to as high as 9.5%. In that case, the payment would increase to as much as $2,522 per month.
Selling or Refinancing within few years?
Borrowers should not rely on selling their home or refinancing again later to keep their rate as low as they have with their initial low rate ARM. In today's difficult real estate market, borrowers may have to wait months or years to sell their home and refinancing may not be an option if home prices drop or if rates are high. One other factor to take into account: some borrowers take out interest only ARMs at low rates for the first few years. Many ARM programs are designed so that not only does the rate change in the first change year but the loan also goes from interest only to fully amortizing. So even if rates stay the same, the payment can rise significantly in that change year.
How about Interest only ARMs at low mortgage rates?
While interest rates on ARMs have only gotten that high for short periods a few times in the past 20 years, there is always the possibility that your ARM rate could hit that level. If you can handle the potential that you might have one or more years of much higher payments on a fully amortizing payment schedule, then taking advantage of lower short term ARM rates may make sense.
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