Mortgage interest rates have held at record lows for longer than anyone could have predicted, driving widespread demand for loan refinancing. Each day that we enjoy low rates, however, is one day closer to their inevitable rise. Tomorrow's higher rates are why switching your adjustable-rate mortgage to a fixed-rate mortgage is so important today.
Escaping an ARM is one of the best benefits of a refinance. Life is unpredictable enough without a question mark hanging over your mortgage payment every year. An ARM makes financial planning harder. Long-term savings goals like college funds and retirement savings can be upturned when a person's mortgage rate adjusts upward.
On the other hand, an ARM might have been the only way for some people to become homeowners. They could qualify for an ARM but not a fixed-rate. The ARM allowed them to buy a house and start building equity at a point in their life when their credit wasn't very good and their job history was shaky. So ARMs have a good side, but … built into them is a ticking clock.
After years of making regular, on-time mortgage payments and holding down jobs, most homeowners enjoy a credit profile better than they had when they were home shopping. They can now think of ditching the risky ARM and getting into a comfortable, predictable fixed-rate mortgage.
“If predictions of an economic recovery on the back of widespread vaccine distribution hold true, rates could rise before the end of the year.”
If You Have 3+ Years Left on an ARM, Make the Switch
On her popular CNBC financial advice show, Suze Orman posed the question, "If you have an adjustable-rate mortgage, should you be refinancing to get a fixed-rate mortgage? What should you be doing?. The answer to that question will depend on how long you're going to be keeping the house you already have."
She urges homeowners in adjustable-rate mortgages to evaluate their refi needs in terms of how long they plan to own the house. This is because it takes time to recoup closing costs.
Loans have closing costs; that is, a price for setting up the loan. Some closing costs are set by the lender itself and therefore negotiable, but other fees are set by third parties. Having to pay closing costs is a fact of life. Luckily when you lower your payment with a refinance, you start recouping the closing costs immediately.
The money you save each month offsets what you had to spend to get the loan started, and eventually you break even. This is called the breakeven point of a refinance. Only after the breakeven point do you actually start saving money.
Breakeven Point = Closing Costs ÷ Monthly Savings
If you plan on selling the house in a year or so, Orman said, "just stay where you are. However, if you're going to be keeping that house for five years, 10 years, maybe even 15 years, 20 years, or longer, and the interest rate on your adjustable-rate mortgage is above right now what a 30-year fixed-rate mortgage happens to be, you might want to look into transferring that."
Homeowners who plan to sell in a year or two won't have time to reach the breakeven point, plain and simple. Granted, those people probably aren't in the market for a refinance anyway. A good breakeven point is 30 months or less, so if you have three or more years left on an ARM, consider refinancing to a fixed rate.
"The key here is you're going to be staying in your house long enough to recoup the closing costs," said Orman.
A 15-Year Fixed-Rate Refinance Is the Sweet Spot
People who have 17-20 years left on their mortgage can hit the sweet spot of refinancing right now by switching to a 15-year fixed-rate mortgage. Those have the lowest interest rates in general, and for months they have been staggering low, hovering around 2%.
Because rates on these loans are so low, a person's monthly payment can go down (or at least not rise) while years get slashed off the loan term. You save a lot in interest for each year you can shave off your debt, and you reach full equity sooner. The timing could be such that your house gets paid of just when a child goes off to college, freeing up much-needed funds, or it makes early retirement a possibility.
Of course, you could refinance for the same number of years that are left on your existing mortgage. Just ask the lender to amortize your payments of that number of years. In adverting you see 15- and 30-year mortgages, but your actual length is up to you. Do not add years to your existing mortgage, though. There is no real savings in going backward.
The Clock Is Ticking
If you have more than three years left on your ARM at an interest rate higher than, say, 3%, a refinance could save you money. The more years you have on the ARM, the more money you could save.
The appeal of fixed-rate mortgages is in the word fixed. Yes, it means you have to time your refinance well, but look around. Today is a great time. That's why 67% of closed loans are refinances, according to a recent Origination Insight Report from ICE Mortgage Technology, formerly Ellie Mae.
"If you wait until the latter half of 2021, some experts say that will be too late to grab the best rates," writes John Csiszar for GoBankingRates. "If predictions of an economic recovery on the back of widespread vaccine distribution hold true, rates could rise before the end of the year."
- Escaping an ARM is one of the best reasons for a refinance.
- Calculate the breakeven point of a refi to know whether it's worth the money and hassle of ditching the ARM.
- An ARM might have been the only way you could buy a home, but after several years of responsible homeownership you can leverage that history into getting a better fixed-rate loan.