Which Mortgage Refinance Option is Right for You?

It's no easy task deciding what to do when your ARM is approaching a mortgage rate reset.

If you have an adjustable-rate mortgage (ARM) that's going to incur a rate reset soon, there's a cliché that describes your situation pretty well: stuck between a rock and a hard place.

In the months approaching your interest rate reset, you have a big decision to make. Should you get a mortgage refinance through traditional channels or through the FHA, or stick with your ARM and hope for the best?  Each option has its pros and cons, and the best decision probably depends on your outlook for the future. Taking them one by one, here are some particulars that will help you make an informed choice.

Traditional mortgage route

In a normal housing environment, you'd probably consider replacing your ARM with a conventional, fixed-rate mortgage refinance. Doing so removes uncertainty by locking in fixed payments and a fixed mortgage rate for the life of the loan. Now's a good time for this option, too, because mortgage rates have dipped below the 5 percent mark.

The obstacle in pursuing this strategy may be the market value of your home. If that value doesn't exceed your mortgage balance by 20 percent or more, you'll have to put in your own cash to get the deal done. This might make sense if you have enough liquidity, and if you intend to stay in the home for the long term. But it's a huge commitment to make at a time when the overall economic environment is uncertain.

FHA loans for the equity-challenged  

When the home's value is insufficient, an FHA loan could be a better mortgage refinance option. This is because FHA loans require only 3.5 percent equity in the home. The drawback is that you'll have to pay the FHA's upfront and ongoing mortgage insurance premiums. The upfront portion is calculated as 1.5 percent of the loan amount; thereafter, you pay 0.5 percent of the loan amount annually.

The no-decision decision

You might be inclined to leave your ARM alone right now, particularly if your mortgage rate will actually go down at the reset. This could be a good call if you plan to sell before the rate resets again. It is a gray area, though, because the current state of the real estate market makes it difficult to project how long it might take to sell your home.

Another source of uncertainty is the future of interest rates. Various economic stimulus programs have dumped billions into our economy. At some point, that massive inflow of cash may create an inflationary environment and put extreme upward pressure on mortgage rates. If that happens, you really don't want to get stuck holding your ARM; there's just too much to lose if your payment skyrockets.

The state of today's economy has littered American lives with rocks and hard places. All anyone can do is make informed decisions and be ready to adapt to unexpected circumstances.