Refinancing an ARM: Damned if you do, damned if you don’t?

by Alex Stenback on April 16, 2009

The Wall Street Journal runs an article today that describes a dilemma that I’ve discussed with many clients this year.  Their profile, from the article:

“These borrowers have a type of adjustable-rate mortgage known as a “hybrid” ARM, which carries a fixed interest rate for a certain number of years and then resets annually to rates tied to market benchmarks. Many of the loans are now resetting to new levels that are lower than the initial fixed rates. That’s because the yields on some common benchmarks used for resetting ARMs, such as the one-year Treasury bond, have fallen to their lowest levels in decades.”

With 30 year rates touching modern-era lows, your first instinct is to refinance out of an ARM, but quick, to lock-in a low fixed rate for the long haul.

Here’s the rub:  As often as not, that instinct is wrong.

A closer look at the numbers mostly reveals the unpleasant reality that you will be paying thousands to refinance into a payment that is the same or higher than the one you have (or will have) when the rate adjusts.

That’s an awful lot of money to pay for piece of mind.

On the other hand, not refinancing here is sort of a trap.  To a great degree, low short-term rates mask your long-term interest rate risk exposure.  

In other words, because both short and long term rates tend rise and fall together (though not always, and never in lock step) there’s a good chance that the moment your ARM starts adjusting upward and you get nervous, fixed rates will ALSO be higher.  Then you’ll really wish you’d grabbed a low fixed rate.

The result is you are left with a choice:  A) Hold your nose and pay the money to refinance even if it results in a higher or similar payment that will never change again, or B) Suffer the slings and arrows of a loan that will adjust with the market forever.

So what’s the best strategy?

There’s no black and white here.  It depends highly on your situation, and requires some analysis, but generally, the longer you intend to remain in the home, the more the risks favor refinancing into a fixed rate. 

If your timeline is less certain, and the thought of having a freely adjusting loan in perpetuity keeps you up at night, it might be helpful to think in terms of average interest rate.  

Rather, don’t focus on the rate you have now, or will have when the loan adjusts.  Focus on the rate you are likely to pay over the life of the loan, or the WACC (weighted average cost of capital.)

For example, lets say you have a 3 year ARM at a fixed rate of 4%, and it adjusts to 6%, and you have the loan for a total of six years.  The average interest you pay over that time is 5%.  That is still an awfully good number, especially when you get it for free.

You can even run the numbers yourself with an online calculator.
· Low Rates Put Borrowers in a Quandary [WSJ]
Not a Numbers Person?  I am.  If you have an ARM and want to know the best approach for your situation, I’d be happy to provide a detailed, professional analysis of your options at no cost.  Inquiries may be directed via alex :at: alexstenback :dot: com or the contact information on this page.

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