Wondering whether it’s finally time to switch your adjustable-rate home loan to one with a fixed rate? Especially now that last year’s jump in mortgage rates has turned south?
After rising for much of late 2018, mortgage rates finally took a breather at the end of the year.
According to Freddie Mac, the government-sponsored enterprise created by Congress, the 30-year fixed-rate mortgage had an average interest rate of 4.6% in 2018 but dropped to a nine-month low of 4.45% in early January.
Lately, rates have been falling even lower, with the average 30-year fixed-rate mortgage coming in at 4.35% in late February.
With 30-year fixed-rate mortgage rates reaching a one-year low in late February, it may make sense for certain homeowners to consider refinancing their adjustable-rate mortgages (ARMs). Here’s a guide to what you need to refinance as affordably as possible and also what you should know about how ARMs work. Plus, if you’ve been on the fence about whether to turn your ARM into a fixed-rate loan, the following pros and cons may help make your decision a little easier.
Benefits of refinancing your ARM
Trading in your ARM for a fixed-rate mortgage can be wise for several reasons. ARMs can:
Lock in a favorable interest rate before future potential interest rate hikes. The Federal Open Market Committee (FOMC) hit the brakes and did not raise the federal funds rate in January. When the Fed funds rate increases, as it has nine times since 2015, it can lead to interest rate increases for a variety of different lending products including mortgages, and especially ARMs.
Recent rate drops are encouraging for consumers, but that doesn’t mean there are no potential rate hikes on the horizon for 2019. LendingTree Chief Economist Tendayi Kapfidze predicted two rate increases by FOMC this year, as the committee works to keep the economy in check. (LendingTree is the parent company of Student Loan Hero.)
Create a stable budget. Adjustable-rate mortgages can make it difficult to budget effectively. This is especially true if a rate change substantially raises your monthly mortgage payment. By switching to a fixed-rate mortgage with a fixed payment amount, you may find it easier to set long-term financial goals.
Potentially lower your interest rate if you took out an ARM years ago. ARMs are set up so consumers initially get an attractively low interest rate for a period of a few months to 10 years (five years for a 5/1 ARM).
After the fixed-rate period is over, the rate typically adjusts at regular intervals according to a predetermined schedule. This usually means the rate on an ARM will then change monthly, quarterly, annually or every three or five years, depending on changes in a benchmark index rate like the London Interbank Offered Rate (LIBOR), as well as the extra “margin” lenders generally add to whichever index rate they use.
If you took out your ARM years ago, your initial rate period may be over and your payments may now be rising faster than you anticipated. As a result, your current ARM rate may now be actually higher than what you might get with a fixed-rate loan.
Downsides of refinancing an adjustable rate mortgage
Refinancing your ARM can also come with potential drawbacks, like the following:
Upfront costs of refinancing. Refinancing costs can add up. For example, closing costs might range from 2% to 6% of your loan amount, and potentially higher depending on your lender. Even with a relatively modest 2% to 3% in closing costs, your refinance could cost $4,000 to $6,000 on a $200,000 mortgage.
Here’s a breakdown of some of the fees you may be required to pay when you refinance your loan:
- Application fee
- Document preparation fee
- Appraisal charges
- Title search and insurance
- Flood certification fees
- Inspection charges
- Recording fees
- Loan origination fees
You may be able to roll some of the fees above into your new loan. However, if you do, you’ll be adding interest, which multiplies the cost of your refinance in the long run.
Opportunity costs. Opportunity cost describes what you have to give up to pay for something else. With a mortgage refinance, you need to consider not only the money you will pay to secure a new mortgage, but also what you could potentially do with those funds if you didn’t opt to refinance. For example, if you invested $4,000 toward retirement instead of using it to pay fees for a new loan, would you be better off?
Potentially higher monthly payment. When you refinance from an ARM to a fixed-rate loan, your monthly payment may increase because lenders generally charge higher rates for fixed-rate loans than initial rates for ARMs. For some, the security of knowing their rate will never change again is worth the trade-off. Still, you should check your budget to see if you can afford a higher monthly payment.
According to Freddie Mac, at the end of February, the average 30-year, fixed-rate mortgage had a 4.35% interest rate, while the average 5/1 ARM rate was 3.84%.
You may need to stay in your home for at least 5 years to recoup fees. If you plan to sell your home within the next five years, a refinance may not be the best move. Even if your new loan comes with a lower interest rate or monthly payment, it typically takes five to 10 years to break even on the upfront costs associated with a new loan. To see how long you’d need to stay in your home before breaking even on refinancing fees, see LendingTree’s refinance calculator.
Consider the loan term
Even if you decide to switch to a fixed-rate loan, check to see which loan term might work best for your finances. For example, it might be better to opt for a 15-year fixed-rate loan rather than a 30-year loan.
With a longer-term loan, you’ll typically secure a lower monthly payment. But a 15-year loan can give you a lower interest rate, allow you to become debt-free faster and allow you to build equity in your home more quickly. The downside: A 15-year fixed-rate loan will most likely also come with a higher monthly payment, so it might be unaffordable for some homeowners who want to refinance.
At the end of February, the average interest rate for a 15-year, fixed-rate mortgage was 3.78%, according to Freddie Mac. You can use LendingTree’s refinance calculator to compare rates for both 15-year and 30-year loans.
The bottom line
So, should you refinance your ARM? To Kapfidze, it’s largely a matter of personal choice.
“With an ARM there’s a possibility your payment could change in the future,” he said. “It might go higher. It might go lower. If you want the security of knowing that your payment is not going to change, consider switching to a fixed-rate mortgage.”
To help determine the best refinance rate for your financial needs, check out LendingTree’s comparison tool for refinancing.
This article contains links to LendingTree, our parent company.