Fed rate policy keeping ARM costs low

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Dear Dr. Don,
We bought a home in California four years ago at $450,000. Our only option at the time was a five-year adjustable-rate mortgage.

I would like to refinance to a 30-year fixed-rate mortgage, but am unable to do so because we are now upside down on the loan.

What would be your best advice? Should I pay more on the principal of the loan or just save the money and wait for the readjustment? Is there anything I can do to better my chances for getting a fixed rate down the line?
— Ann Adjusts

Dear Ann,
A good first step — if you don’t already do it — is to monitor where your mortgage would reset if it adjusted at today’s rates. The loan documents will spell this out. Or, you can talk to your lender.

Floors, ceilings and maximum interest rate movements for one reset date (or over the lifetime of the loan) can play a part in determining where the interest rate will reset, so look for that information, too.

You can follow most of the interest rates used in pricing ARMs by checking out Bankrate’s “Rate Watch” feature, which tracks leading interest rates. If you know the pricing spread on your mortgage, figuring out where it would reset today is a matter of simple addition.

For example, the spread (margin) on a cost of funds index ARM — known as a COFI ARM — is typically 2.25 percent to 3 percent above the level of the index.

The COFI for the 11th District of the Federal Home Loan Bank System is the index typically used in pricing a COFI ARM.

Once you start monitoring where your loan would reset, you can calculate the monthly loan payment using Bankrate’s “Mortgage payment calculator.” You’ll know whether you need to start building a fund to help finance the new payment or you can work on paying down the existing mortgage by making additional principal payments.

One ray of sunshine in the current interest rate environment is that the short-term interest rates used to price ARMs are at very low levels.

The Federal Reserve isn’t likely to start raising its targeted federal funds rate any time soon, and may actually cut rates, placing downward pressure on other short-term interest rates. That should make you feel a little better about not being able to refinance into a fixed-rate loan prior to the first reset on your 5/1 ARM.

Keep in mind that the decision to refinance should be based in part on how long you plan on staying in the house. Paying thousands in closing costs to refinance to a fixed rate loan doesn’t make sense if you only plan on being in the house for a couple of years.