Should you refinance your ARM before it resets?
February 25th, 2008 Posted in Adjustable Rate Mortgage, RefinanceYou may be better off refinancing your adjustable rate mortgage (ARM) and paying a little more now in order to save a lot more down the line.
Most people choose adjustable-rate mortgages (ARMs) over fixed-rate loans because of their lower initial monthly payments. However, the rate and monthly payment of an ARM is eventually adjusted, or reset. For example, a 5/1 ARM resets after five years, and then annually after that. During periods of falling interest rates, the adjustments can be welcome. When rates are rising, however, you’ll have to brace yourself for higher monthly payments.
In order to help you determine whether you may benefit from refinancing, consider the following:
The rate caps on your mortgage
If you have an ARM that is about to reset, it’s crucial that you understand the caps on your loan. Caps are limits on the amount your interest rate (and, subsequently, your monthly payment) can go up. They are designed to protect you from the shock of extreme rate increases. There are three main types:
The initial cap limits the amount your rate can go up at the first adjustment period.
The periodic cap sets the maximum increase for any single adjustment.
The lifetime cap restricts the overall amount your interest rate can be raised over the entire mortgage term.
As an example, imagine that you have a 3/1 ARM with an initial rate of 4 percent. Your initial and periodic caps are both 2 percent, and the lifetime cap is 6 percent. Now let’s assume your mortgage will reset for the first time in one month, and interest rates have risen since you obtained your loan. If your new fully indexed rate were 6.5 percent, your initial cap would protect you, keeping your actual rate at just 6 percent.
Note, however, that your loan will be adjusted again a year from now, and even if interest rates stay the same, your ARM will go up to 6.5 percent, because an increase of 0.5 percent is still well under the periodic cap of 2 percent. As long as interest rates continue climbing, your mortgage rate will climb with it, by a maximum of 2 percent a year, until the lifetime cap halts the increase at 10 percent. That’s why caps may not provide long-term protection against rate increases.
