The downside of a shorter-term loan is the monthly payments on the refinance are higher. For example, a $300,000 5/1 ARM at 3.25 percent would have a monthly principal and interest payment of $1,306 for the initial, five-year fixed-rate period. A $300,000, 15-year fixed-rate loan at 3.625 percent would have a monthly principal and interest payment of $2,163.
Qualifying for an ARM refinance
Kullman says most lenders require 20 percent equity for a refinance, although some allow 10 percent equity for borrowers with excellent credit and income.
"The problem is, if you have less than 20 percent equity, you will need to pay private mortgage insurance (PMI), which will add to your monthly payment," Kullman says. "PMI companies don't particularly like ARMs, either, so they are likely to charge higher PMI premiums if you choose an ARM."
Kullman says ARM borrowers will be qualified for their loan based on an interest rate that is 2 percent higher than the initial rate.
"In other words, if you are applying for an ARM that starts at 3.5 percent, you need to have the debt-to-income ratio to qualify for your loan amount at 5.5 percent," Kullman says.
If you decide the low monthly payments associated with an ARM are worth the risk when you refinance, Kullman recommends choosing an ARM with a longer term than you think you need.
"If you plan to move in three years, I'd suggest a five-year ARM to be on the safe side," says Kullman.
Jablonski says that in the rare event of borrowers having absolute certainty about their ability to sell their home or pay off their mortgage before the loan resets to a potentially higher rate, an ARM refinance could make sense.
"However, borrowers need to account for the possibility they would have to pay the maximum payment," says Jablonski. "But, most important of all, no one should ever use an ARM to be able to afford a larger mortgage. That's a slippery slope, because if you have trouble qualifying for your loan, any little hiccup in your income can cause problems."