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April 4 , 2005
Is Refinancing
Your ARM Right For You?
"With interest rates expected to
rise, is this not a good time to refinance my ARM into an FRM?"
It may be a good time for some, not for
others. The trick is to know whether it is a good time for you.
The gain (or loss) from refinancing an
adjustable rate mortgage (ARM) into a fixed-rate mortgage (FRM) depends partly
on what happens to interest rates in the future, which is not knowable. But it
is also affected by other factors that we do know � or can find out. These
factors should swing the decision. To illustrate the point, here are two
examples.
A Borrower Who
Should Not Refinance
John Doe has an ARM with a rate of 4%, and
can refinance into a 6% FRM. Doe expects to be out of his house in 4 years and
his ARM rate does not adjust for 2 years, subject to a 2% adjustment cap.
Subsequent adjustments occur annually, subject to the same 2% adjustment cap and
a 10% maximum rate. It turns out that even in the worst case of an interest rate
explosion, Doe will do better staying with his ARM than refinancing into the FRM.
A Borrower Who
Should Refinance
Jane Smith can also refinance into a 6% FRM
but her ARM rate is 5%, it adjusts in a year, and she expects to be in her house
for 10 years. Further, she has a higher margin on her ARM than Doe, which will
result in a 6.5% rate at the next rate adjustment if the market index does not
change. It turns out that even if rates are stable in the future, Smith will do
better with the FRM.
These are extreme examples and most borrowers
will fall between them, which makes the decision process more difficult. To make
it manageable, Chuck Freedenberg and I have developed a new calculator, number
3e in the menu of calculators on my web site. It pulls together all the factors
relevant to the decision, and generates one bottom-line number: the net dollar
savings or cost from switching from ARM to FRM over the borrower�s time horizon.
An ARM-Into-FRM
Calculator
Here are some of the major factors the
calculator uses:
Time Horizon:
In general, the longer the borrower expects to remain in the house, the stronger
the case for the refinance. More bad things can happen to the ARM over a longer
period.
ARM Features:
Refinance is a less attractive option for ARMs with particularly desirable
features. These include a low current rate, a long period to the next rate
adjustment, a low rate adjustment cap, a low maximum rate, and a small margin.
Note: The margin is added to the rate index to determine the new rate on an
adjustment date, subject to the adjustment cap and maximum rate.
FRM Features:
The rate on the new FRM will be higher than the ARM
rate, but much depends on how much higher it is. Further, account must be taken
of refinance costs, including points, other lender fees and other settlement
costs, all of which reduce the benefit of a refinance.
Prepayment Penalty:
A prepayment penalty on the ARM acts just like an additional fee on the FRM,
since you only pay it if you refinance.
Mortgage Insurance:
If the borrower is paying for mortgage insurance on the ARM but the house has
since appreciated, the FRM might not require the insurance. Even if it is
required, the premiums on FRMs are lower. This would be a partial offset to the
costs of the FRM.
Assumptions About Future Interest Rates:
A critical factor affecting the results is the assumption you make about future
interest rates. Calculator 3e allows you to assume many different future rate
patterns, including the "stable index" and "worst case" assumptions used in my
illustrations above. Another approach is to specify a rate increase each year,
beginning in a specified year, and continuing for a specified number of years.
A Refinancing
Decision Strategy
One decision strategy is to try rising rate
scenarios of increasing severity until you find the one in which the costs of
the ARM and FRM in your case are about the same. This tells you how big a rise
in rates is required to make refinance into an FRM profitable for you.
If I did this, for example, and found that
any increase in rates greater than .5% per year for 3 years made the refinance
profitable, I would refinance. If I found that it took a 2% rise each year for 5
years for the refinance to be profitable, I would stay with my ARM. If the
results fell between these two, I would consult my astrologist.
Copyright Jack Guttentag 2005
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