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Ask Dr. Don

Should I refinance now or later?

Dear Dr. Don,
I have an ARM (adjustable-rate mortgage) at 6.375 percent that will go up in October 2004 to 7.375 percent. If I refinance before October it will cost me $7,540 in penalties. I have an offer of a 5.625 percent 30-year fixed rate on a $385,000 loan. I plan on staying in my home for at least 10 years. With rising interest rates, should I pay the penalty or wait until October to refinance on the chance that the rates will be higher?
Cheryl Compare

Dear Cheryl,
Chances are good that short-term rates will be higher in October. There are three meetings of the Federal Open Market Committee between now and then, and odds are that the committee will decide to raise the targeted fed funds rate at one of those meetings. Whether that action translates into higher interest rates for 30-year fixed-rate mortgages isn't as clear cut, but it's not likely that you'll be able to get a 30-year fixed-rate mortgage at a rate lower than the 5.625 percent you're being shown now.

Getting out of an ARM before short-term rates start heading higher can make a lot of sense, especially if you plan on being in the home for the next 10 years. Refinancing using a 10/1 ARM is a compromise that may allow you to capture a slightly lower interest rate than the 30-year fixed rate.

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The table below is a rough estimate of the risks you face by waiting to refinance in October. I didn't consider closing costs because you're paying closing costs whether you refinance now or in October.


Waiting until October costs you about $4,800 for every one-eighth of a percentage point increase in interest rates. Rates would have to increase by less than one-quarter of a percentage point for you to break even on your prepayment penalty. Use Bankrate's mortgage calculator with its amortization schedule, like I did, if you need to create your own table.

Between the certainty of an increased ARM rate and the probability of higher fixed rates in the fall, it makes sense to refinance now. I'll be the first to tell you that I don't know where interest rates will be in October, but they don't have to move much higher for you to be better off paying the prepayment penalty and capturing the current rate.

-- Posted: June 17, 2004

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See Also
Refinancing an ARM
The "Farewell To ARMs" refinance
Financial advice glossary
More Dr. Don stories

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