The days of interest rates hovering near 3 percent for fixed-rate mortgages seem to have disappeared, with the Freddie Mac Primary Mortgage Market Survey reporting that the average rate on a 30-year fixed-rate loan stood at 4.45 percent as of Jan. 10. This doesn't mean, though, that there aren’t any reasons to refinance your existing mortgage loan in 2019.
And if you do decide to refinance? It might make sense to refinance to an adjustable-rate mortgage, a loan type better known as an ARM.
Fixed-rate refinances are most common
Usually, homeowners refinance to nab a lower interest rate, something that might not be possible with today’s higher mortgage interest rates. But there can still be reasons to refinance. Some homeowners with longer-term loans, though, might consider applying to mortgage lenders for a refinance to a shorter-term mortgage with a lower rate. Borrowers with FHA mortgages who've reached 20 percent home equity might refinance to eliminate monthly mortgage insurance premiums. And homeowners looking to borrow money might consider a cash-out refinance.
But what about refinancing to an ARM? Is that ever a good move?
How ARMs work
The main benefit of an ARM is that the initial interest rates they come with are typically lower than the ones you'd qualify for if you were taking out a standard fixed-rate mortgage
But that lower rate only remains in place for a set number of years, usually from five to seven. After the fixed period ends, the interest rate adjusts according to whatever financial indices it follows.
This means that ARMs come with more uncertainty than do fixed-rate loans, where the interest rate never changes. After the fixed period ends, the odds are high that your interest rate will increase. You won't know, though, exactly how high it will jump.
If you refinance to an ARM, you will have to live with some uncertainty. You'll also need to study your household budget to make sure you can handle the higher monthly mortgage payment that will come if your interest rate does adjust higher.
Why refinancing to an ARM could pay off
In addition to the lower initial interest rate, ARMs also offer borrowers more flexibility. Many homeowners who've had a 30-year mortgage for awhile like to refinance into a 15-year fixed-rate loan to get a lower rate and shave several years off their mortgage. But doing so means higher monthly payments, since you're paying more loan principle each month. You'll pay less interest over the full term of the loan, but your monthly payments will be higher than they would be with a longer-term loan.
What if you want to reduce the interest you pay but you’re also worried about that larger monthly payment? An ARM might be an option. ARMs are usually amortized over 30 years, but the rates can be similar to those on a 15-year fixed-rate loan. So you get the lower interest rate with smaller minimum monthly payments - but you can pay more each month if you wish.
So you’ll still have the flexibility of making a larger monthly mortgage payment – perhaps even as large as the one you’d be required to make with a 15-year loan – if you want. If money is tight for a few months? Then you can make the smaller, minimum payment without penalty or falling behind on your loan.
By making larger payments when they fit within your budget, you can reduce the interest that you pay, but you won’t be locked into the larger payments required of a 15-year mortgage.
Adam Smith, president of The Colorado Real Estate Finance Group in Greenwood Village, Colorado, said that ARMs are often a good choice for homeowners who don't plan on living in their homes for longer than, say, five or seven years
That's because these homeowners will move out, and get a new mortgage, either before their ARMs adjust or shortly thereafter, reducing the risk of higher future interest rates. Others might refinance, if they’ve built up enough equity in their homes, before the adjustable period begins.
"If you don't plan on living in your home forever, then by all means, consider an ARM," Smith said.
Consider the popular 5/1 ARM. The first number tells you that your initial interest rate will remain in place for five years. The second number -- the 1 -- indicates that the interest rate will adjust every year after the fixed period ends. With a 5/5 ARM, the initial interest rate remains in place for five years and then adjusts once every five years after.
The uncertainty with ARMs does make some homeowners nervous. But Smith says that ARMs usually come with caps that limit how much an interest rate can adjust. Your cap might state that your interest rate can only adjust by 1 or 2 percentage points during its initial adjustment period. If you start your ARM with an interest rate of 3.5 percent, a cap of 2 percentage points means that your rate can't jump higher than 5.5 percent during this initial adjustment.
An ARM might also come with a lifetime cap. This type of cap spells out the maximum number of percentage points your loan's interest rate can rise during the lifetime of your mortgage. Your lifetime cap might be set at 5 percent, meaning that your ARM's rate can never increase more than 5 percentage points from its starting point.
Not all agree that ARMs are a smart move
Not all financial professionals recommend ARMs. Jim Angleton, president of Miami-based AEGIS FinServ Corp., said that he does not recommend ARMs for any borrowers. The risk of rising interest rates are too high.
Angleton recommends that borrowers worried about the size of a monthly payment with a 15-year loan stick with a 30-year, fixed-rate loan. They can then make larger monthly payments when they can afford them. When they can’t, they can make the lower required payment that comes with a 30-year loan. This approach still gives homeowners the chance to pay off their loan's balance faster and reduce the amount of interest they pay, Angleton said.
What are your goals?
Joseph Dionne, assistant vice president of operations with Orlando, Florida-based Home1st Lending, said that homeowners should look at their goals before choosing a specific ARM type. If you are focused on the lowest monthly payment and are willing to live with more uncertainty, you might explore an ARM that comes with a shorter introductory fixed period.
If you want less uncertainty, you can explore ARMs that come longer fixed periods and adjust a smaller number of times during their lifespans.
"The shorter the introductory fixed-rate period, the greater the savings," Dionne said.