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Refinancing with an ARM

Hello Dr. Don,
I enjoy reading your advice and information column. I purchased a home two months ago with a 5.125 percent mortgage rate (5.5 or less APR) on a 30-year term.  I'm also paying PMI.  A friend told me it may be worth refinancing with a variable rate based on prime or LIBOR to have more of my payment apply toward principal.  Would this be worth doing, and what are the pros and cons involved besides it being a variable-rate loan?
Thanks,
Tarek Topic

Dear Tarek,
With a variable-rate loan, the homeowner is accepting the risk that interest rates head higher.  Since the lender doesn't have to shoulder that risk, they can simply price the loan at a spread to the pricing index, whether that's LIBOR, COFI, a constant maturity Treasury index, the prime rate or some other index.  You can follow the movements in these indexes using Bankrate's Rate Watch page.

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As your friend points out, the attraction of an adjustable-rate mortgage (ARM) is that the lower interest rate allows for higher monthly principal payments as shown in the example below:

 

30-year fixed

1-year ARM

5/1 ARM

Loan balance:

$150,000

 $150,000

 $150,000

Interest rate:

5.125%

3.88%

4.14%

Mortgage payment1:

 $816.73

$705.78

$728.28

First month's principal:

 $176.11

$220.78

$210.78

First month's interest:

 $640.63

$485.00

$517.50

You can increase the potential savings with an ARM by making additional principal payments equal to the difference between your old fixed-rate payment and your new ARM payment.  Using the payments from the example above, you'd make additional principal payments of $111 a month if you had a one-year ARM.  This not only reduces the effective loan term but also reduces the risk of rising interest rates as the principal balance goes down.

A 5/1 ARM will have the initial interest rate locked in for the first five years of the loan.  The interest rate will reset at the end of the five-year period, and reset annually thereafter.   It allows you some certainty in the early years of the loan when you may be least able to handle rising mortgage payments.

If you can use the mortgage interest deduction on your taxes, the difference between the fixed and adjustable mortgage rates is less when compared on an after-tax basis.  A rough estimate of this is (your mortgage rate) x (1 - your tax rate) as shown below: 

 

30-year fixed

1-year ARM

5/1 ARM

Nominal interest rate

5.125%

3.88%

4.14%

Effective after-tax rate1:

3.69%

2.79%

2.98%

You're two months in on a 30-year mortgage, and you've got a very good interest rate.  Refinancing on the chance that you can pay down your principal balances faster with an ARM before interest rates head higher doesn't make sense to me -- especially when you consider the closing costs in refinancing your new mortgage.

For a second opinion take Bankrate's Fixed vs. Adjustable-Rate Mortgage decision tool for a spin to see if a variable rate-mortgage is right for you.  Then use Bankrate's Refinancing Calculator to see how many months it will take for you to recoup your estimated closing costs -- assuming that the rate on your ARM stays constant over that time period.

If you go shopping for an ARM, make sure you understand how it's priced, floors and ceilings on rate movements, both per reset and over the life of the loan.  Find out if an ARM loan has negative amortization provisions, which can increase your loan balance over time.

-- Posted: July 30, 2003

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See Also
8 must-ask mortgage and refi questions
Four steps to a stress-free refi
Financial advice glossary
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National Mortgage Rates
OVERNIGHT AVERAGES
Rates may include points.
30 yr fixed mtg 4.25%
15 yr fixed mtg 3.23%
5/1 jumbo ARM 3.55%



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