If you've got an adjustable rate mortgage (ARM), you may be feeling some pressure to refinance now before your rate resets. However, for some borrowers, waiting may not be such a bad idea.

Many people assume that your rate automatically increases when your ARM resets. But that's not the case. It's possible that your rate can actually go decrease after a reset, particularly when prevailing rates are low, such as they are now.

ARM rates can go down

When your ARM resets, your new interest rate is based on a formula tied to some index representing prevailing market conditions. In most cases, it will be something like the Cost of Funds Index (COFI), London Interbank Offered Rate (LIBOR) or a Treasury-based index like the Constant Maturity Treasury (CMT). Your new rate is the index rate plus a fixed adjustment (called the margin), such as 2.5 or 3 percent, which is determined at the time you take out the loan.

Generally, the index rate plus the fixed adjustment will produce a new interest rate that's somewhat higher than the initial interest rate you'd pay on a new ARM. But if market rates have declined since you first took out the mortgage, your rate could reset lower than what you were paying - from 6 percent to 4 percent, for example.

Finding out what will happen with your own mortgage is simple. Get out your mortgage documents and find out what index your reset will be based on and what your margin adjustment will be. Look up what the current rate on your index is, add the margin, and you'll have what your new rate would be if you refinance today (the maximum increases or decrease is limited to a cap specified in your mortgage).

Refinancing to lock in rates

But even if you'd get a lower rate by letting your ARM reset, refinancing may still be a good idea. Rates are unusually low right now, and ARMs typically reset again each year after the initial reset. So if rates increase over the next few years, you might wish you'd locked down a long-term rate now while rates are low. And if your ARM isn't due to reset for six months to a year, rates might already be higher by the time it resets.

Allowing your ARM to reset instead of refinancing can make sense for a variety of other reasons as well. Maybe you think you might be moving within the next two or three years and it wouldn't be worth it to pay several thousand dollars to refinance for that short a time. Or your home value has dropped and you want to see the market stabilize before refinancing. Or you need additional equity to qualify for the best mortgage rates, so you need to pay down additional principal before refinancing.

Of course, if you have an option or Alt-A ARM where you're going to need to make increased principal payments once your ARM resets, you'll probably want to go ahead and refinance if possible. But that may be difficult, as many homeowners with those types of loans have not accumulated enough home equity to qualify for a refinance, particularly given the steep declines in home values in recent years.

    Published on December 21, 2007