Time To Replace Your ARM With A Fixed-Rate Mortgage?

Should you refinance to a higher mortgage rate?

It's not that crazy an idea. If you have an adjustable-rate mortgage (ARM), chances are that you're sitting pretty right now with low monthly payments, thanks to the rock-bottom interest rate environment we're experiencing now.

But the question is, how long can this party last? Almost all interest rate forecasts show that mortgage rates must increase soon, whether that's increasing over the next few months or next few years.

Refinancing your ARM while fixed-rate loans are also at very low mortgage rates could be a smart move. There's no one-size-fits-all solution, but here's a step-by-step guide to deciding whether to refinance.

1. Assess the terms of your adjustable-rate mortgage

Every ARM has terms that determine how and when its interest rate adjusts. Examine your mortgage's index (usually published online), margin (the percentage added to the index), adjustment and lifetime caps (which restrict how high your rate can go) and rate floors (which restrict how low your rate can go), if applicable. Also check to see if the home loan has a prepayment penalty.

2. Try some refinancing scenarios

Once you refamiliarize yourself with the terms of your mortgage, you can game out some scenarios about where your interest rate and payment may go over the next several years.

Let's say your mortgage rate is at 3.5 percent today, that it's not allowed to go any lower, and it adjusts every six months with a 1 percent adjustment cap.

• Your worst-case scenario is that your rate steps up a percentage point every six months until it reaches its lifetime cap.
• Your best-case scenario is that it stays at its 3.5 percent floor forever.

Neither of these extremes is likely, but you might be able to determine which is more realistic. For example, if the underlying financial index is LIBOR, you can get a look at historical LIBOR data to see that the index averaged 3.23 percent over the ten years from 2000 to 2010.

If your current loan's margin is 3 percent over LIBOR, you might reasonably expect your fully indexed rate to average 6.23 percent over the next decade (though of course your rate at any given time could vary considerably -- which is why there are caps to decrease your loan's volatility).

It's one thing to have a vague sense that your rate may go up soon. Reviewing historical norms can give you a more precise indication of likely adjustments.

3. Think through a breakeven analysis

The breakeven analysis for refinancing from an ARM to a fixed-rate mortgage is different from that of a regular interest-rate-reduction refi. That's because your savings are determined by future interest rates, and of course you don't know what they will be.

However, you can still plug in an interest rate that makes sense to you. The most conservative approach is to assume that the interest rate will hit its adjustment and lifetime caps; a more moderate approach assumes the ARM would adjust upward to something approximating the index's recent historical average rate, plus the margin (so 6.23 percent using the hypothetical ARM above).

If you were to refinance given today's low ARM rates, your savings will be negative -- because your new loan will have a higher rate than your ARM. Only once the ARM rate exceeds your fixed rate do you get positive savings.

Therefore, if you won't be keeping your home more than a few more years, a better approach might be to use the money you would have spent on a refinance to pay down your loan balance. Or consider refinancing to a hybrid ARM that can give you a fixed interest rate for three to seven years and carries a rate that's about 1 percentage point lower than a 30-year fixed rate. That cuts your breakeven time considerably.

4. Run the numbers on a mortgage calculator

If you're not planning on leaving your home within a few years, it's more likely that a refinance would pay for itself. Use a monthly mortgage payment calculator with an amortization schedule to see what your loan might do over the time you expect to keep your home.

First, look at the effect of refinancing to a fixed-rate mortgage. Your new payment will be higher than your ARM loan payment, for now.

Next, compare the fixed-rate payment to your ARM payment in a worst-case scenario. If your adjustment cap is 2 percent and your current rate is 3.5 percent, use a mortgage payment calculator to see what your new payment will be at 5.5 percent, 7.5 percent and so on until you reach the point when you plan to sell the property or hit the lifetime cap.

Here's the bottom line: If a worst-case scenario could cause you to lose your home, strongly consider refinancing to a safer fixed-rate loan.

Run the numbers again, this time assuming an average rate. See how long it takes for your ARM to increase to the point that the fixed-rate alternative gives you the lower payment and saves enough to cover to cost of refinancing. A quick and dirty way to approximate this is to use a refinance calculator and use the average ARM rate as your current interest rate.

The refinance-or-not-to-refinance decision is tougher today because interest rates are so low -- it's hard to choose the best deal. But it's not such a bad thing to have so many good mortgages to choose from. Especially if you haven't been in the home loan market for a few years, contact an experienced lender to get more expert guidance on your mortgage decision.