Should You Keep Your Low-Rate ARM?

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The vast majority of homeowners who are refinancing their mortgages are choosing fixed-rate loans, opting to lock in at a historically low rate. But many homeowners who currently have adjustable-rate mortgages (ARMs) charging even less may balk at this move, since it can increase the monthly payment.

Is keeping that ARM a mistake? It depends on the borrower’s situation and long-term plans, but there are some ways borrowers with ARMs can continue to enjoy today’s low rates and keep future risks in check.

The key risk, of course, is that the rate can go higher in future resets, which are typically done every 12 months after the first one, three, five or seven years. Right now, many borrowers with ARMs are paying at the mouth-watering rate of around 3%. That’s what you get by adding a typical 2.75-percentage point margin to the yield on Treasury securities with one year to maturity, a standard index for ARM resets.

A 3% rate leads to substantial savings over a 30-year fixed-rate loan, which averages 4.481%, according to the BankingMyWay.com survey. For a $200,000 loan, the ARM would charge $843 a month and the fixed loan $1,011, according to the ARM vs. Fixed Rate Calculator.

But the fixed rate is very low by historical standards, and it will stay the same for the life of the loan, while the ARM could go higher. Many ARMs have caps that allow rates to rise only as much as two percentage points a year or six points over the starting rate during the life of the loan. Five years ago, the initial rate was around 5%, so an ARM issued then could someday go as high as 11%.

How can a homeowner with an ARM continue to enjoy today’s low rate while minimizing the damage from any future rate hikes?

The simplest way is to sock those monthly savings away to help make the bigger monthly payments if the ARM rate goes up. Use the Adjustable Rate Mortgage Calculator to figure what future payments would be if the rate were to rise at the fastest pace allowed by your mortgage.

Money saved for this purpose should go into bank savings, such as a certificate of deposit or money market account, so there’s no risk of loss and you’re sure the cash will be available when you need it.

The second approach is to use the monthly savings from the low ARM rate for extra principal payments on the mortgage. Reducing the debt minimizes the monthly payment required after the next reset, since the new payments are based on the years left on the loan, the new interest rate and the remaining loan balance. Pre-payments can dramatically reduce the amount of interest paid over the life of the loan.

In effect, these extra payments earn a savings yield equal to the loan’s interest rate, since they allow the borrower to avoid interest charges at that rate. If your ARM currently charges 3%, an extra payment would earn 3%, which is better than when saving in a bank. The BankingMyWay.com survey shows the average savings account yielding just 0.193% and the average five-year CD only 1.741%.

The downside: Extra money put into the mortgage is tied up, while bank savings are easy to get at and available for any purpose.

Because you cannot know what rate your ARM will charge over the years, it is impossible to figure just how pre-payments will affect your payments in the future.

If you plan to have the home for longer than six or seven years, it would probably be best to refinance to a fixed-rate mortgage, as we may never again see fixed rates as low as we do today. If your ARM someday charged 7-9%, or more, you’d regret missing the chance to lock in a fixed rate below 5%.

If you expect to leave the home within two or three years however, it probably makes sense to stick with your ARM rather than refinance. Your rate is low now, and if it jumps in a year or two you won’t be stuck with it for long.

If you’re somewhere in the middle, expecting to keep the home for three to six years, or perhaps a bit longer, keeping the ARM is a gamble worth considering. Rates may stay low for several years, and caps could then keep your payments from quickly getting out of hand. By sticking with the ARM you already have, you also could avoid spending thousands of dollars on refinancing fees.

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