If Rates are Low, Should Everyone Refinance their ARMs?

I’d like to thank Dave for inviting me over here to Serious Real Estate to talk a little bit about mortgages. I’m a mortgage banker who normally hangs around my blog, Illinois Mortgage Rates and News.

Refinancing is suddenly hot again. Rates are dropping and this could be a chance for a lot of people to redo their mortgage and save some money. But the question is, does refinancing make sense for everyone who is paying a higher interest rate? No way. Even if it does make sense, the mortgage guidelines have changed, and some of the people who would benefit the most aren’t going to be able to qualify. Refinancing will help a lot of home owners, but whether it helps you or not depends on a lot of things, not just how low of an interest rate you can get. Let me explain.

One of the big issues now is the huge number of adjustable rate mortgages that will come due and reset this year. I’ve seen estimates as high as one trillion dollars – that’s one with twelve zeros behind it! That is serious money, and I’ve read a lot of commentary about how damaging this could be to our economy this year. But if you are one of those people with an ARM, should you be worried that your interest rates are going to go pop up and make your payment unaffordable? Probably not. In a lot of ways ARMs have gotten a bad rap. To see how an ARM reset would affect you, you need to understand how an ARM works.

The most popular versions are what is called hybrid ARMs. That means they were fixed for a certain time span, usually 3, 5 or 7 years, and converted into a one year ARM after the fixed period ended. So how does your ARM reset? The ARM changes are based on two things that are set up at the beginning: the index, and the margin. The first part, the index, refers to the financial indicator the rate is based on. Different indexes are used, but they all move up and down based on the strength of the economy. The second part of an ARM loan is the margin. This is set at the closing, and it always stays the same. So the first step to see what your new rate will be is to add the margin to the index. The current 1 year treasury index, a common index in ARM loans, is now around 3.25%. Adding in the margin, typically 2.75%, you get a fully indexed rate of 6.0%. This is an increase, sure, but not a back breaking one. And this index is moving down. It doesn’t reflect the recent Fed cuts in short term rates. So if you are adjusting in the coming months, the new rate will be even lower.

But this doesn’t necessarily give you your final rate. There’s one more step. Most ARMS have caps built in to them. Your rate typically can’t increase more than 2% per year, and no more than 6% over the lifetime of the loan. (That’s not the case with all ARMs, so take a look at your mortgage note to make sure.) So if you bought your home back in 2003 with a 5 year ARM, and maybe you bought when rates were near the bottom with the starting rate at 3.75%, if your cap is 2% at the first adjustment, your new rate can’t be higher than 5.75%.

The other thing to keep in mind is how long you plan on staying in your home. If this is your forever home and you want to stay there for the long term, it makes sense to refinance and lock in to the current low rates. If you are going to be there for at least a few more years, refinancing will still make sense, especially if you refinance with low or no closing costs. But if you don’t plan on staying in your home for more than a year or two, you’re better off doing nothing. The worst case scenario isn’t all that bad.

If you have an ARM with a sub prime mortgage your situation might be worse. The margin on Sub Prime loans can be 6%, which means your payment could shoot higher causing real problems. If you have an Option ARM and you’ve been paying just the minimum payment, you owe more now than when you started, and you are on track for some real trouble. In these cases refinancing makes a lot of sense, but with the changes in mortgage guidelines you may find it hard to qualify. But that’s a topic for another post.