Refinance Into an Adjustable-Rate Mortgage

If you are interested in the lowest possible mortgage rate for your refinance, consider refinancing into an adjustable-rate mortgage, or ARM. Because ARMs tend to have lower initial interest rates than their traditional 30-year fixed-rate counterparts, ARM refinances are especially popular when mortgage rates begin to rise and consumers need a lower-cost option.

Three reasons to refinance into an ARM
Here are three advantages of refinancing into an adjustable-rate mortgage:

1. Lower mortgage rates: Interest rates on ARMs are often lower than 15-, 20- and 30-year fixed-rate mortgages.
2. Perfect product for soon-to-be home sellers: "If you know the end period when you will sell your home, pay off the loan in full or refinance, an ARM can be a good loan," says Douglas Benner, a senior loan officer with Embrace Home Loans in Rockville, Maryland. "Some people know for certain they are retiring to another home within a few years, or they know they will come into some money or be transferred to another area. In that case, it makes sense to save the money in interest payments during the initial few years of the loan."
3. Improve your financial standing: Keith Gumbinger, vice president of HSH.com, says another candidate for an ARM refinance is a homeowner who is waiting for the economy to recover, or for his or her personal finances to improve. For this kind of homeowner, an adjustable-rate mortgage provides valuable short-term stability. "This can be a great product to tide you over for a few years as long as you save money while you are using an ARM," says Gumbinger.

Why are ARM mortgage rates lower?
"With short fixed-rate periods, lenders can take on far less interest rate risk when making ARMs than when they write long-term fixed-rate mortgages," says Gumbinger. "Although it depends upon the ARM as well as market conditions, ARMs tend to have lower interest rates than 30-year fixed-rate mortgages. Unlike most fixed-rate mortgages, which are sold to others, lenders also find ARMs to be desirable and profitable additions to their own portfolios of loans, so they may price these aggressively at times in order to capture business."

Should I refinance into an adjustable-rate mortgage?
Knowing how long you plan on staying in your current home is perhaps the most important factor when deciding whether or not to refinance into an ARM. After all, it's a waste of money to pay all those refinance closing costs -- typically equivalent to a couple of percentage points of the new loan amount -- if you aren't going to live in the property long enough to recoup the cost of your refinance.

Here are three scenarios to help you decide if ARM refinancing is right for you:

• You're staying in your home for just a few more years: If you only plan to stay in your home for another one to three years, refinancing probably isn't in your best interest because it doesn't give you enough time to realize the savings of your refinance.

• You're moving somewhat soon: If you're going to remain in your property for three to five years, refinancing into a new five- or seven-year ARM is probably your best move. You want to stay in your home long enough so that your new, lower interest rate allows you to recoup your closing costs. Plus you'll have protection against rate increases.

• You plan on staying in your home for the long haul: If you plan on living in your home for an extended period, chances are you will stay in your home longer than the fixed-rate portion of the adjustable-rate mortgage. This opens you up to the possibility that the ARM will reset to a higher interest rate as the years go by, and you could end up with a rate even higher than the rate you would have gotten with a fixed-rate loan.

How are adjustable-rate mortgage rates determined?
ARMs start out with a fixed-rate period, often one, three, five, seven, or 10 years. During this initial loan period, the ARM is essentially a short-term fixed-rate loan. ARMs with longer fixed-rate periods typically have slightly higher mortgage rates, says Gumbinger.

After the fixed period, the mortgage rate adjusts according to the loan terms. In the case of a 5/1 ARM, the loan adjusts every year following the five year fixed-rate term. One of the major determinants to the adjusted interest rate is the index to which the mortgage is linked.

"Most ARMs are adjusted according to the LIBOR (London Interbank Offered Rate) index, a market interest rate which is based on the global economy, and some are adjusted according to Treasury securities, which are more closely tied to Federal Reserve decisions," says Gumbinger. "Studies have shown that both of these indexes end up in about the same place over time, but borrowers should ask about the index and understand how it works."

How to prepare for mortgage-rate changes
You have to ask yourself, "Can I handle an appreciable increase in my interest rate at some point down the road? Can I handle my monthly payments if my interest rate doubled? Am I prepared to potentially dedicate my savings to my mortgage if my payment jumps?"

Refinancing to a lower interest rate is going to save you some extra cash each month, no question. In order to prepare for a mortgage-rate increase, you have to take at least some of the savings you gain from that initial lower rate and bank them -- preferably in a high-yield account. If you can save all or even some of those savings, you can build yourself a "mortgage subsidy account" on which you can draw upon if your payment should increase, ameliorating the effect on your budget to a real degree.

(Michele Lerner contributed to this article.)

This article originally appeared on hsh.com.

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