Wednesday, 27 February 2019

Over the past decade, getting an adjustable rate mortgage was a relatively safe bet.

Following the housing crash in 2007, the Federal Reserve cut the benchmark interest rate to an all-time low of 0.25 percent and didn't start raising rates again until 2015.

This promise of low rates for the foreseeable future made Adjustable Rate Mortgages (ARMs) very attractive, particularly for first-time buyers who could use ARMs to get into their first homes for less than, with a fixed-rate mortgage.

But rates have been going up steadily since 2015, and some predict mortgage rates could top 5 percent in 2019, the highest in over a decade. Which means if you got your loan when rates were hovering near zero, and it's about to start adjusting, you probably need to explore your options.

In most cases, there are three basic options: do nothing, refinance into another ARM or refinance into a fixed-rate loan. Which one is right for you depends on your situation, but each has pros and cons, and understanding them can help point you in the right direction. So, let's break them down.

Option 1: Do Nothing.

The upside of doing nothing is you won't pay closing costs, which you will if you refinance. But the downside is your monthly mortgage payment may increase. To determine how much, revisit the details of your loan, including how your new rate is calculated and how often it adjusts.

For example, let's say your fixed-rate period is for five years. After that, your rate will adjust annually.

ARMs are typically tied to a major index, such as the one-year Treasury bill. Which index your loan is tied to is in your loan documents, and the margin is the number set by your lender when you apply for your loan. For this example, let's say your margin is three percentage points.

When it's time for your rate to adjust, your lender will calculate your new rate by adding three points to the current index rate and will then round that number to the nearest eighth (Example: margin = 3 plus index = 0.49, then it would be 3.49% and would be rounded to 3.5%). This will be done once a year thereafter.

You can use online mortgage calculators to help estimate your new monthly payment. If your payment will increase only slightly, it probably makes sense to wait another year and see where rates are instead of spending what could be thousands of dollars to refinance. However, if your payment will jump dramatically, refinancing might be the way to go.

How long do you plan to stay in your home?

This is an important factor in determining which option is right for you. If you're in it for the long haul, it might make sense to refinance into a fixed-rate loan. But if you plan to move in the next few years, the cost of refinancing might outweigh making a slightly higher payment for a year or so.

Option 2: Refinance into another ARM.

If you plan to stay put for five to seven years, this could be a good choice. You will pay closing costs, but with another ARM, you'll typically get a lower rate during the initial fixed-rate period than you would with a conventional fixed-rate loan, which could save you money.

On the other hand, please note that you should compare what your current rate could be versus what the new ARM rate could be. Refinancing into a new ARM could possibly place you in a higher fixed rate than you are currently paying.

How much is your mortgage?

Seems like a simple question, but when figuring out what to do with your ARM, it's very important. That's because with a larger loan, say $500,000, even a small rate increase can make a big difference in your monthly payment. Whereas with a $120,000 loan, a small rate increase will have a relatively small impact.

What about closing costs?

Again, having to pay closing costs is probably the biggest downside of refinancing. Whether you refinance into another ARM or a fixed-rate loan, you'll be looking at between two and five percent of the amount of the loan in closing costs. Here again, the amount of the loan makes a big difference as five percent of $500,000 is a whole lot more than five percent of $120,000.

Option 3: Refinance into a fixed-rate mortgage.

Again, time is a key factor here. If you plan to stay in your home for more than 10 years, a fixed-rate mortgage is probably a good solution. As the name implies, with fixed-rate loan the interest rate is fixed — remains the same — the entire term of the loan.

You will pay closing costs to refinance into a fixed-rate loan, but since you plan to stay in the home for an extended period, this will allow you to recoup your closing costs over time, and you'll probably save money in the long run. You'll also have the peace of mind of knowing your monthly principal and interest will never change, regardless of interest rate fluctuations.

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