Dear Dr. Don,

I am in a 5/1 adjustable-rate mortgage at 4.875 percent which will have its first interest rate change in July 2010, and I’m wondering if I should refinance.

When my rate changes in July, the new rate will be 2.25 percent plus the one-year Libor index. With the Libor index currently at 1 percent, the new rate would be 3.25 percent. I am considering refinancing at 3.5 percent with no points into another 5/1 ARM with 5/2/5 caps and closing costs of $2,300.

My FICO score is 774 and the house is conservatively valued at $900,000. The loan balance is $278,000. I used a refinancing calculator and — assuming a 30 percent tax rate — the break-even is 11 months for total savings versus prepayment. I have two freshmen in college and have considered downsizing, but with my low payments and no other debt, moving is a huge hassle. I could stay put for another three to four years.

Should I sit tight and wait until closer to July 2010 in view of the historically low rates? Or, should I refinance now for an even lower rate of 3.5 percent and roll the closing costs into the loan?

— Angelena Adjusts

Dear Angelena,

First, you need to take a look at the interest rate caps and floors on your existing mortgage. You’re checking to make sure that the first interest rate change would in fact drop the existing mortgage to 3.25 percent if the loan were reset at today’s one-year Libor index. The mortgage may have a floor rate above the 3.25 percent. You can follow the one-year Libor index on Bankrate’s Rate Watch page.

If you refinance now, your mortgage interest rate will decline from 4.875 percent to 3.5 percent. Assuming you capture that interest rate differential for four of the next six mortgage payments, the difference in interest rates will recoup about half the closing costs on the refinancing.

I don’t quite follow how you calculated the break-even for refinancing at 11 months. If nothing happens with Libor between now and the reset date, and there’s no floor rate to consider, you estimate the existing mortgage will reset at 3.25 percent. The new rate for 12 months is lower than the interest rate on the refinancing. You’re paying more in interest, not less, after the change date.

What you’re really accomplishing with the refinance is to lock in the next five years of a mortgage at 3.5 percent so you don’t have to worry about what happens to the one-year Libor index over that five-year horizon. Think of the closing costs as an insurance premium paid to protect you against higher interest rates over that time period. The fact that you reduced the interest expense for the next few months just reduces the cost of that insurance.

Since you’re only planning on being in the house for another three to four years, a 5/1 ARM makes perfect sense for the refinancing versus a conventional fixed-rate mortgage. If you’re not really sure about whether you’ll still be in the house five years from now, you should be looking at other mortgage products in deciding whether to refinance. Such products might include a 7/1 ARM or a conventional fixed-rate mortgage.

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