ARM Mortgagees Faced with Refinancing Conundrum

Mortgage rates on adjustable-rate mortgages (ARMs) skyrocketed last year, so many homeowners are eager to do a mortgage refinance into a safer and more affordable fixed-rate loan.  However, interest rates have fallen, which may mean that it's still cheaper to stay in an ARM and let it reset to the new lower rate.

People who have ARM mortgages may find themselves in a quandary. Last year, as millions of ARMs reset, homeowners saw payments skyrocket, sometimes doubling in a single month.  Since then, the Fed has slashed rates, and a mortgage reset today may automatically give the borrower a much lower rate and save the expense and hassle of a mortgage refinance.

Consider, for example, a typical 5-year ARM that started out with an enticing "teaser" rate of 4.5 percent, followed by resets that are calculated by taking the 1-year Treasury rate and adding a premium of 2.75 percent. When those ARM mortgages reset about a year ago, the 1-year Treasury rate was 3.3 percent, so homeowners used to paying 4.5 percent suddenly awoke to payments exceeding 6 percent (3.3 plus a premium of 2.75 = 6.05). But today, rates are so low, that resetting would drop the above loan to an unbelievably cheap 3.25 percent-which is lower than the introductory teaser.  Snagging that kind of sweet deal is the primary goal of choosing an ARM in the first place.

Mortgage refinance quandary

In today's market, consumers who had been planning to refinance into a fixed-rate loan to avoid an expensive reset would have to pay hefty refinance fees, and would likely walk away with a higher monthly mortgage payment. That's because 30-year fixed mortgage rates have been trading in a range of around 4.75 to 5.25 percent. Paying the bank to take you out of a 3.24 percent ARM and put you into a new loan that's two points higher doesn't make sense to most homeowners.

Low mortgage rates for the long term

However, it might still be a wise move to refinance, even if it will be more expensive in the short term. That's because a low fixed-rate, like the ones available in today's market, will last throughout the term of the loan, while the ARM will reset to higher levels when the economy recovers and interest rates begin rising again.  When mortgage rates begin their move to the high side, that 5 percent long-term rate will seem like a steal.

Another argument for refinancing is that many ARM loans have limits or "caps" that keep the interest rate from resetting beyond a certain point. If the rate is supposed to increase by 3 percentage points, but has a 2 percent cap, it will only move two points. That protects the borrower from higher payments when rates jump, but also prevents him from enjoying the full benefit of sudden rate drops like those we're experiencing now.

These refinancing choices will depend on individual circumstances, so homeowners with ARM mortgages should plan carefully and not act impulsively.