If you are ready to refinance, you likely know you have two options – a fixed rate mortgage or an ARM. While the fixed rate mortgage is pretty self-explanatory and is often a simple choice, the adjustable rate takes some consideration. There are times when the adjustable rate mortgage does make sense, though.
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Keep reading to learn the times when it might make sense for you.
You are Moving Soon
If you need to refinance, but know that you will move in the next few years, why not consider an ARM? You get the low teaser rate and save even more money each month. Here’s a quick tip: the smaller your introductory or teaser period, the lower the interest rate. If you know, for example, that you’ll move in the next 2 years, why not take a 3-year ARM? The rate will adjust after you move and yet you get to take advantage of the low rate from the start.
Of course, you’ll want to proceed with caution if you are moving. Unless you have concrete plans, such as your job contract requires you to move in a certain number of years, you’ll want a little cushion. Maybe rather than taking the 3-year adjustable rate, choose the 5-year. This way you have a better chance of actually moving before the rate adjusts.
The ARM/Fixed Rate Spread is Large
When you apply for a refinance, you’ll receive rate quotes from each lender you contact. If you ask, they’ll let you know the adjustable rate and the fixed rate they can provide you. Using the two rates from one lender, you can determine the ARM/fixed rate spread. Here’s an example:
John receives two quotes from Lender A. The 30-year fixed rate is 5.0% and the 3-year ARM is 4.5%. The spread is then 0.5%. That can make a big difference in his payment. Assuming he has a $100,000 loan, his payments would be as follows:
- Fixed rate – $537
- Adjustable rate – $507
You’d save $30 a month for the first 3 years. That’s a total savings of $1,080. While it’s not a huge number, it does save you money in the end.
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On the other hand, let’s say the lender quoted John a 5.0% on the fixed rate and 4.875% on the adjustable rate. The fixed rate spread would be:
- Fixed rate – $537
- Adjustable rate – $529
$539 – $529 = $10
Since the spread is only $10, John would save $360 over a 3-year period. That might not be worth it. Obviously, the larger the spread, the more sense it makes to take the adjustable rate.
The Risks of an ARM
Before you consider an ARM, you must know the risks involved.
The name adjustable rate likely makes you think long and hard before taking it. Just what will the rate adjust to? While you will know the maximum the rate can be, you won’t know from year-to-year what interest rate you will pay. It depends on the market and how it performs. You run the risk of an extremely elevated rate, but also have the benefit of a possibly decreasing rate.
If you have variable income, you may want to reconsider the risk of an ARM loan. Without knowing the exact payment amount in the coming years, you could put yourself at risk for default. Unless you have stable income that will either increase with a standard raise or remain the same, taking a chance on a higher payment can be too risky.
So should you or shouldn’t you refinance into an ARM? It really depends on your circumstances and threshold for risk. If you can take the gamble that the new rate will be much higher, go for it. You stand to save money in the long run. If, however, you need a more predictable payment and don’t plan on moving anytime soon, the fixed rate may be the better choice.
