Should You Refinance an ARM Loan?

An ARM is a type of loan with a low interest rate that changes once the adjustment period ends. Shutterstock

If you have an adjustable-rate mortgage (ARM) that’s approaching the end of its term, you might be considering refinancing. Your interest and, consequently, monthly payment may increase depending on the economy, and you might be nervous about how your payment will be adjusted.

An ARM can be beneficial; it will give you a low interest rate at the beginning of a loan. But what are the positives and negatives of an ARM, and how do you refinance them when the higher interest hits?

How an ARM Works

An ARM is a type of loan with a low interest rate that changes once the adjustment period ends. They have a fixed rate at the beginning of the loan. Typically, the rate would be fixed for five, seven, or 10 years. Your interest rate remains the same during this time, so your payments remain the same.

After this time ends, the mortgage could increase or decrease based on the index rates and financial markets. They adjust periodically.

For example, if you have a 5/1 ARM, the interest rate is fixed for five years and then adjusts once per year for the rest of its term. With a 7/6 ARM, the interest rate is fixed for seven years and then adjusts every six months.

This is unlike a fixed-rate mortgage, which has the same rate and monthly payment for the loan’s duration.

Although it depends on the ARM how often the rate can change, caps and floors are usually in place. These set the minimum and maximum your rate can go.

The rate can’t increase or decrease more than a certain percentage over the life of the loan.

When deciding to take out an ARM, it’s prudent to calculate the maximum possible monthly payment you could have—that way there aren’t any surprises.

Can You Refinance an ARM?

Refinancing an ARM is like refinancing a fixed-rate mortgage. You’ll need to qualify when you apply for one. You’ll use the proceeds from the new mortgage to pay off the ARM.

In order to qualify for a refinance, most lenders have specific qualifications. They include:

• 5 percent home equity minimum
• credit score of 620 for a conventional loan or 580 or higher for a VA refinance loan or FHA
• debt-to-income ratio (DTI) of 50 percent or less

You can choose to refinance with the same lender who financed your ARM or find a different one. Compare lenders and find the one that can offer you the best rate.

Refinancing an ARM’s Cost

Refinancing isn’t free. Ensure you understand the costs. There will be a lot of expenses, including:

• origination fees
• appraisal fees
• title fees

However, the refinancing costs are lower than the closing costs on a home purchase loan. The total cost depends on your loan amount. Plan on paying 2–5 percent of the loan amount.

For example, if the balance of your ARM is $250,000, you may end up paying $5,000 to $12,500 in closing costs.

You’ll note the closing costs are similar to a purchase loan. But since you’ve probably paid down the original price and you'll be financing a lower amount, even though the percentages are the same, it will cost you less.

Why Move to a Fixed-Rate Loan

When deciding to move to a fixed-rate loan, take into account your credit score. If your credit score has increased and your DTI has lowered, you might qualify for a lower rate on a fixed mortgage. You’d also be eliminating the risk of your monthly payment increasing.

If you have a lot of equity in your home, you might be able to go without mortgage insurance, that will lower your payments, as well.

Refinancing an ARM Advantages

The main benefit of refinancing an ARM is stabilizing your payments. Moving to a fixed rate ensures you’ll have predictable monthly payments. It allows you to budget better. And you’ll avoid rate fluctuations and circumvent potential spikes.

There are also the short-term potential interest savings if interest rates are lower than what you’re paying. You'll also be able to access your equity. This could provide funds for home improvements or other expenses.

Renegotiating loan terms is also possible when refinancing an ARM. You may want to adjust the duration or specific conditions.

Refinancing an ARM Disadvantages

Like any loan, switching to a fixed-rate loan has some disadvantages. For some people, paying closing costs again is an issue. But a lower interest rate may offset this. Closing costs vary depending on the lender, so look for one who keeps those to a minimum.

You'll also have an extended loan duration. When you refinance, the clock resets. For example, if you already have a 30-year loan and refinance to another one, you’ve lost those first five years; you’re starting over again. This could lead to more interest over time.

And, finally, some ARMS have prepayment penalties if you refinance or pay off the loan early.

Refinancing an ARM May Work for You

If you don’t plan on staying in your house long, you may not be interested in refinancing an ARM. But for those of you in it for the long haul, refinancing an ARM may be a wise choice.

You’ll avoid the fluctuations in monthly payments that come with an ARM. Although the payment could be lower, there’s always a risk it will increase. A fixed-rate loan allows you to budget more consistently. But ultimately, it depends on your finances and intentions.

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