What the Downgrade Means for Your Mortgage

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NEW YORK (MainStreet) -- In the drama leading up to last week’s Treasury bond downgrade, experts warned the move could drive interest rates up. Well, the stock market intially plunged but bond yields have stayed low. Still, the downgrade does present a dilemma for homeowners with adjustable-rate mortgages.

Experts have been saying for years that interest rates were more likely to rise than fall during the economic recovery, so people with ARMs would be smart to refinance to fixed-rate loans. But borrowers who stuck with their ARMs have done just fine. Many are now paying around 3%, because of low rates on indexes used for annual resets. Anyone who refinanced today to a 30-year fixed-rate loan would pay about 4.6%, according to the BankingMyWay.com survey.

Clearly, owning an ARM involves a bet on future rates, and that bet has become a little riskier because of the U.S. debt downgrade.

If you believe rates will rise, so that you’ll pay more than 4.6% in coming years, it would make sense to refinance to today’s low fixed rate while you still can. Refinancing would also pay if a hike to the maximum rate allowed by your ARM would leave you struggling to make payments.

But what if you don’t have a strong feeling that rates will rise? And suppose you could handle that worst-case scenario? In that case, it might pay to stick with the ARM in the hope that rates will stay low. Several steps can minimize the risks of this strategy.

First, set aside enough cash to cover closing costs on a refinancing, so you can move quickly if rates start to go up significantly.

Second, count the savings you enjoy from your low ARM rate as just that – savings, not spending money. There are a couple of things you could consider doing with it.

One is to invest the savings in extra principal payments on your mortgage. By paying down the principal, you could minimize the payment if the rate rises before the next reset. Resets are like getting a new loan, with the new payment based on the new interest rate applied to the remaining debt for the time left on the loan.

Paying down principal doesn’t appeal to everyone, because it means tying that extra cash up in the home. If that bothers you, put it into some other form of savings or investment.

If you put it into something liquid and safe, like bank savings, you’ll be able to get at it for a more profitable investment when market conditions are less tumultuous.

One option: If your ARM rate is likely to jump in a future reset, use these savings to make a one-time, lump sum principal payment on the loan. That will reduce the payment you’ll face after the subsequent reset.

After that, you’d have another decision to make: Stick with the ARM despite the higher rate, in hopes rates would come down again, or plan to refinance if rates threaten to go even higher.

Keep in mind that if ARM rates spike, rates are sure to be higher on fixed-rate loans as well. Hanging on to your ARM could mean losing the opportunity to refinance at today’s low fixed rates.

—For more tips and tricks on getting the most out of your home loan, visit MainStreet’s “Mortgages” topic page for our latest coverage!

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