Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Refinancing an ARM

Dear Dr. Don,
We have a five-year ARM and have lived in our home for one year. We may end up living in it longer than five years and are wondering if we should refinance. Our current interest rate is 4.5 percent and we owe approximately $295,000. Our home is worth about $475,000.

As interest rates will start to climb eventually, should we consider refinancing at this time? We would definitely have a higher mortgage payment. Would it make more sense to make additional principal payments on our current mortgage to reduce the principal before refinancing down the road?
Shelli Shelter

Dear Shelli,
Look at the costs associated with refinancing before deciding to refinance. Is there a prepayment penalty on the current mortgage? What do you estimate closing costs to be on the new mortgage?

You say your plans have changed and now you expect to stay in this home for more than five years. How much more? Refinancing to a 7/1 adjustable-rate mortgage or a 10/1 ARM would allow you to have a lower current interest rate than moving to a fixed-rate mortgage. You'll still take on the interest rate risk at the end of the fixed term, but you've postponed that day of reckoning by refinancing with a new ARM.

Fixed-rate mortgages have been heading higher over the past month because of higher Treasury yields in the longer maturities. The pricing indexes for ARMs are based on short-term interest rates and haven't moved as much. Plus, the Federal Reserve doesn't expect to raise its fed funds rate in the immediate future. Bankrate's Fed Watch feature can keep you informed on the Fed's actions and comments while the Rate Watch feature keeps tabs on interest rates.

In the table below, I've used Bankrate's mortgage calculator and U.S. average refi rates to show how different refinancing strategies change your monthly payment.

Getting a new 5/1 ARM gives you an extra year in the house before the interest rate resets and a lower monthly mortgage payment. The trade-off is in the closing costs. Saving $200 a year in mortgage payments doesn't mean much if you have to pay $6,000 in closing costs to realize that lower monthly payment. Loans with longer resets have higher payments, but you have a lower mortgage payment than you would by having a 30-year fixed-rate mortgage -- at least through the initial interest rate period.

Making additional principal payments can help. For example, if you paid $332 a month in additional principal payments, the difference between a new fixed-rate loan and your current mortgage payment, over the remaining four years until your current mortgage interest rate resets, you'll reduce your principal balance by an additional $17,425, lowering it to $255,901. That's still a pretty big loan balance to expose to the vagaries of the market for interest rates in 2007 when your current loan resets.

A lot of things can happen between now and 2007, but it's likely that both short-term and long-term interest rates will be higher than they are right now. If you've convinced yourself that you're in this house for the long term, then it makes sense to consider your refinancing options now.

-- Posted: Aug. 19, 2003