refinance

Refinance rental property to knock away ARM?

Don TaylorDear Dr. Don,
In 2005, we bought a town house in a northern suburb of Chicago with a five-year adjustable-rate mortgage, or ARM. I think that back then, the interest rate was 5.5 percent. Anyhow, it took only 5 ½ years to lose 50 percent of the house's original value.The five-year interest rate lock expired, and the ARM reset at 3 percent. The next year, it reset even lower to 2.8 percent. It went up slightly last year, back to an even 3 percent.

We have since moved out of the home and have it rented. At this rate, what is now our rental property will be paid off in 15 years and we can hopefully turn a bad experience -- the housing bubble -- into a positive one.

Is this a good time to refinance? Our rate adjusts from 2.75 plus what the one-year Treasury bill is in July. Our mortgage payment is $800, but we pay $1,200 every month. What kind of trouble can I get into five years or 10 years down the road following this same path, with the rate resetting?

Am I going about it the right way? Keeping the interest rate relatively low, paying more every month?

Thank you in advance!
-- Albert Amortization

Dear Albert,
With Federal Reserve Chairman Ben Bernanke prepared to keep our financial markets awash in liquidity, there's not likely to be any upward pressure on short-term interest rates anytime soon. Treasury bill rates take their cues from the targeted federal funds rate, and the expectation is for the Fed to keep this rate at or near zero percent through at least 2014.

Taking the other side of the argument, you may be able to refinance and lock in a 15-year fixed-rate mortgage at close to your current 3 percent rate. At the time this column was published, Bankrate's national average for a 15-year fixed-rate mortgage was 2.95 percent. The problem is in how much equity you have in your home.

If your home's value was cut in half between the time you purchased it and 2011, then you may not have the equity to refinance, even with your seven years of making additional principal payments.

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What makes it even harder is that a mortgage refinance on what is now a rental property has different credit standards and interest rates than a conventional fixed-rate mortgage. You'll need to have a substantial equity position in the property -- typically 25 percent -- and proof of rental income. With those standards met and with your good credit, you should be able to score a rate that's within one-quarter to one-half of a percentage point of what's available for a conventional fixed-rate loan.

If you don't have that kind of equity in the property, you could see if you're eligible for refinancing under the federal Home Affordable Refinance Program, or HARP. It's designed to help homeowners refinance if they have an underwater mortgage. Investment properties can qualify for HARP.

Assuming you plan to hold on to the house over time, the key variables are the closing costs and the interest rate. You're not expecting a lower mortgage payment, so look at the closing costs as the price of an option to convert the rental property to a fixed-rate loan. Rates can't go much lower, so there's only the risk of interest rates rising. While that's manageable in the short term, if you can get within half a percentage point or less of where a 15-year conventional fixed-rate mortgage is, then I'd suggest a refinance to lock in a fixed rate.

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