 |
Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
•
Bankrate.com |
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.
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
|
|
1 Assumes all loans have a 30-year
amortization schedule.
|
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%
|
|
1Assumes
a federal tax rate of 28% and no state income tax
|
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
|
