Today I wrote a post that explained how to analyze a simple rate-and-term refinance. Now we'll step through something more complex, involving a hybrid ARM, or adjustable-rate mortgage.
This query comes from the comments in a recent blog post. A reader named Mark writes: "Should I refinance now or wait? I have a 30-year, 7/1 ARM now. My seven-year fixed rate of 4.25 percent expires next year, June 2011. The arm is with LIBOR with a margin of 2.25 percent, with a cap of 2 and 5. My loan-to-value is 54 percent, with a credit score of 787. Loan amount $260,000. I can get a 20-year loan with no closing cost at 4.5 percent."
Mark doesn't mention which Libor rate the loan is indexed to. I'll assume it's the 1-year Libor, which is 1.15 percent this week. Here's the Bankrate page where you can look up Libor rates.
Mark's rate won't adjust until next year, but let's calculate what it would be if it were to adjust based on this week's 1-year Libor. The new mortgage rate would be the Libor rate plus the margin. The Libor rate is 1.15 percent and the margin, as Mark mentioned in his question, is 2.25 percent. So the combined rate would be 3.4 percent. Note that Mark is paying 4.25 percent now, so the rate actually would drop if his loan were to adjust next month instead of next year. Libor has been rising, and there's no guarantee that it will be under 2.25 percent a year from now.
When Mark says he has caps of 2 and 5, he's saying that the rate can't move more than 2 percentage points from one year to the next, and the maximum rate is 5 percentage points above the introductory rate. That makes the maximum possible rate 9.25 percent. In that unhappy scenario, his monthly payments would be about $850 higher than they are now.
Now Mark has to think hard and take some guesses. What does he think will happen to the Libor a year from now and two and three years from now? In the worst case, could he handle the payments under a rate of 9.25 percent? Does he think such a rate is likely to befall him if he keeps the ARM?
How will he feel if he refinances now, and the Libor is the same a year from now? Under that scenario, he goes from 4.25 percent to 4.5 percent, and his payments remain unchanged a year from now, whereas under a Libor they would fall. Would he avoid kicking himself for that?
The answer to Mark's refi-or-not question depends, in some measure, upon his appetite for risk and his ability to not look back. It's as much about psychology as it is about numbers. I'll offer this bit of advice: In the case of co-borrowers, if one partner is a risk taker and the other isn't, go with the wishes of the risk-averse borrower for the sake of harmony.