Refinancing–Can You Afford To Wait?
In a meeting earlier today, an associate agreed that anyone with an adjustable rate mortgage should consider refinancing into a fixed rate. As the discussion progressed, I realized my associate had an interest-only ARM himself. Since the ARM had a “fixed” rate period, he wasn’t considering his own mortgage when he made the comment about refinancing.
This mindset could be a problem for many borrowers who, because of their “fixed” period, haven’t considered that they need to refinance yet. The risk—-by the time the “fixed” period expires, the rate adjustment may be so high that the payments are no longer affordable.
While there is no way to predict exactly what rates will do over the next several years, it’s a fair guess that they probably won’t be as low as they have been in recent history.
What does this mean to the average homeowner with an ARM?
Every ARM has caps and margins which are added to the index rate when the rate is going to adjust. If your caps are 5/2/5, that means on the first adjustment period, the rate can increase up to 5%, the annual increase thereafter is a maximum of 2%, and the maximum over the life of the loan is 5%. The new rate will be determined by adding your margin to the current index rate. So if your margin is 2.25 and the current index is 6, then you add 2.25 to 6 to get your new adjusted rate of 8.25. The caps are there to ensure that your rate can’t go above the maximum increase allowed for the loan program.
What does this mean in terms of monthly payments?
Let’s say, if you locked your 3/1 Libor ARM at 5.5 a year ago and the caps are 5/2/5 with a margin of 2.25, that means 2 years from now if the libor, currently at 4.35, is 6.35 the new interest rate will be 8.6 percent. If you’ve made interest-only payments on your $300,000 loan, you still owe $300,000. Therefore, your interest-only monthly payment which was $1375 is now $2150. That’s a $775 per month increase which would significantly impact most individuals’ budgets.
If the same loan were refinanced now into a 30-year fixed rate of 6%, the principal and interest (P & I) payment would only be $1798.65, an increase of only $423.65. Even adding escrow in most cases would keep the payment below the $2150 of the earlier scenario. And, on top of the fact that your principal and interest payments will never increase, you also have the benefit of making monthly payments toward the principal instead paying only the interest. This ensures you build equity even if the real estate market cools considerably and property isn’t appreciating very much.
So the question is can you afford to wait? While you must also consider the cost of refinancing into a new mortgage, it may still be more cost effective than risking a significantly higher payment down the road.