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When you purchased your home, you may have chosen an adjustable-rate mortgage (ARM) because it offered a lower interest rate. However, at a certain point, you may be thinking about refinancing to a fixed-rate mortgage.
In this article, we’ll explore adjustable-rate mortgages and when it makes sense to refinance or wait it out a little longer.
Why Are Adjustable Rate Mortgages Attractive to Homebuyers?
With mortgage rates at levels we haven’t seen in more than a decade, homebuyers are looking for ways to reduce the cost of owning a home. This is a popular option for some because an ARM offers an attractive introductory interest rate, lower than what you’d receive from a fixed-rate mortgage.
With an ARM, your interest rate remains fixed for a period of time, typically three, five, seven, or ten years. Once the introductory period is over, the rate becomes variable and adjusts every six to 12 months.
Even though there is some uncertainty about what your future interest rate will be with an ARM, several advantages make them attractive.
Lower Initial Interest Rate
Many people choose an ARM because of the lower introductory interest rate. For example, on July 26, 2024, the average interest rate on a 5/1 ARM was 6.44%, compared to 6.88% for a 30-year fixed-rate mortgage.
Flexibility When Rates Are High
Because many people will use an ARM to receive a lower interest rate, you will have flexibility. If you’re not planning to stay in the home for long, you’ll be able to enjoy the lower rates and have time before your interest rate starts to fluctuate.
An ARM will also give you time to wait for interest rates to drop before locking yourself into a fixed rate.
Deciding If You Should Refinance Your ARM or Wait
While it’s tempting to refinance an ARM with a fixed-rate mortgage as soon as rates drop, there are factors you should consider before moving forward.
Knowing How Long You Plan To Live in the Home
Each time you refinance your mortgage, you’ll pay closing costs. These can be anywhere from 2 to 5% of your loan amount.
For a $250,000 mortgage, closing costs could be between $5,000 and $12,500. While these can be included in your loan, you’ll pay interest on this amount.
Before you choose to refinance to a fixed-rate mortgage, consider how long you plan to live in the home. Then, do a cost-benefit analysis to determine whether a lower interest rate today would outweigh the cost of a new mortgage.
If you think there is a chance you may move before your introductory fixed-rate period expires, it might make sense to hold onto your current loan and see what happens with interest rates.
Understand The Interest Rate Cap
Many lenders use different interest rate caps to protect borrowers from drastic interest rate increases. Below are a few you’ll want to consider before deciding whether to refinance now or wait things out.
Initial Adjustment Cap
When you first get an ARM, your loan will have an introductory fixed-rate period. Once the introductory term is over, the interest rate will adjust based on current interest rates.
If rates have increased significantly since you took out your mortgage, your adjustable rate could also increase significantly, making your mortgage unaffordable.
Luckily, lenders offer an initial adjustment cap, which limits the rate increase when you move from the fixed rate period to the adjustable rate period. While the lenders set this cap amount, it’s typically either two or five percent.
Subsequent Adjustment Cap
Once you’ve moved from a fixed rate to an adjustable rate and had your initial rate adjustment, your rate will continue to adjust every six or 12 months. However, lenders also cap these increases at 2%, which means your interest rate can’t be more than 2% higher than the previous period.
Lifetime Adjustment Caps
To keep interest rates at a manageable level, lenders cap their increases over the entire life of the loan. While some lenders can choose to cap the rate increase at any level, many will set a 5% lifetime cap.
That means if you initially take out an ARM with a 3% interest rate, the highest the rate could become would be 8%.
You can use these different caps to decide if it makes sense to refinance today or wait for rates to hopefully decline.
Understand What Interest Rates Might Be In The Future
While it’s hard to predict what will happen with mortgage rates in the future, you can consider current news to help your decision-making process. For example, recent inflation data showed a 2.5% increase in consumer prices in June 2024.
Because this is more in line with the Federal Reserve’s target, it’s becoming likely there will be interest rate cuts in the second half of the year.
Depending on when your ARM is scheduled to adjust, you can use data like this to determine whether it makes sense to refinance now or wait to see what happens with mortgage rates.
The Bottom Line
Adjustable rate mortgages can be a great way to get a low interest rate on your home loan. However, it’s important to understand how they work so know when it makes the most sense to refinance to a fixed-rate mortgage.