Why You May Not Need to Refinance
Foreclosures, flagging home sales, mortgage-meltdown headlines -- and bears, oh my!
The events of recent years have brought the risks of adjustable-rate mortgages (ARMs) into the public eye. If you're a homeowner with an ARM, the question of whether you should try to refinance your mortgage can keep you up at night.
Mortgage pros recommend that you focus on three factors to make your decision:
- How long you plan on staying in your home.
- Which way you think interest rates will go.
- How well you can withstand rate fluctuations.
Based on my cocktail-napkin calculations, the answers to those questions will get you roughly 18.2% of the way to the right result.
As with so many financial decisions, it's the details that matter -- and those fine points of refinancing make up (again, in my estimation) that other 81.8% of the equation. In short, refinancing isn't right for everyone.
ARM wrestling: Who holds the cards?
If you're thinking about dumping your ARM, remember this: Refinancing products are being hawked by the same industry that aggressively pushed these nontraditional loans in the first place.
You should be just as careful getting your ninth loan as you were getting your first. Since the process is completely in your control -- there's no moving date looming -- it's easier to take your time and do it right.
5 key questions
Here are the considerations that will help you devise a refinancing strategy:
1. Do you really have a "risky" loan? Not all ARMs are created equal. The riskiest ones offer flexible payment options and carry rates that adjust frequently -- anywhere from monthly to every six months. (Not surprisingly, they also provide the biggest commissions for the brokers selling them.) Surveys show that 70% to 80% of option ARM holders make just minimum payments. The danger with such loans lies in ignoring the adjustments -- easy to do, since the required payment may change only once a year.
However, there's no need to wait for a warning bell -- your lender's hand is hovering over the buzzer. Once you're in negative amortization land and owe 110% of the original loan amount (some have a cap of as much as 125%), the bank will require fully amortized payments. That's what they can stomach. But remember, it's not their roof at risk if you're forced into foreclosure.
Traditional ARMs include long-term adjustment periods. Some come with an interest-only option. But even if your ARM is due to reset soon, refinancing isn't necessarily a slam-dunk decision. So let's keep digging.
2. How damning will the rate adjustment be? It's not enough to say, "I have a five-year ARM." You need to dig deeper. What index is your rate tied to? When does your loan adjust? What is the annual cap? What is the lifetime cap? And -- this is an important one -- what is the initial adjustment cap?
According to an independent mortgage-advice site run by Jack Guttentag, professor emeritus of finance at the Wharton School and founder of mortgage technology company GHR Systems, rate increases are fairly standardized on all but the five-year ARMs (second only in popularity to one-year ARMs at the time of his survey). The initial adjustment cap on five-year ARMs ranged from two to six percentage points -- a small detail that could have huge long-term consequences.
Say you started out with a loan with a 6% rate. If it caps the first rate adjustment at two percentage points, you'd face a maximum rate of 8%. But if it has an initial rate cap of five percentage points, you could pay as much as a whopping 11% interest rate. That's quite a handicap right out of the gate.
3. What's your FIR? One critical input in your refinance research is the current fully indexed rate (FIR) of your ARM -- the current rate of the index your ARM follows, plus the margin. "This is the best available predictor of how your ARM rate will change," Guttentag says. You'll find the index and your margin in your loan paperwork. For the current rate of the index, go to mortgage-x.com.
When the FIR rate is higher than the fixed-rate mortgage (FRM) rate, refinancing might make sense. However, if the rate for your ARM is currently below the FRM as well (the most common scenario), it makes sense to wait until the next adjustment to refinance, unless you are extremely risk-averse.
4. When do you reach your breakeven point? Don't let loans that emphasize the monthly payments cloud your judgment. Instead, look at the total cost of refinancing, which isn't as straightforward as you might think. It's not as simple as just comparing your upfront costs with your monthly savings. Keep in mind how quickly you'll pay off your mortgage, and consider the lost interest on the money you use to pay refi costs and any prepayment penalties that apply.
5. Why did you pick an ARM in the first place? Maybe you chose an option-payment ARM because you have an unsteady income -- a common situation for small-business owners or commission-based employees. Maybe you didn't expect to live in your home very long. Did you get an interest-only loan so you could free up cash for other investments? Perhaps you got an 80-10-10 loan, or a "piggyback mortgage" -- a primary loan subsidized by a home equity loan or line of credit -- to avoid paying private mortgage insurance.
Plans change. It's important to re-examine your original motivation and see whether those inputs have, too. Look at the equity you've built up. Take a truthful look at how you're handling that "freed-up" cash. Are you investing it or blowing it at the mall? Research home values, which affect your ability to move up or sell. And check your credit report, particularly if you were forced to take a subprime loan because of past bloopers.