Refinancing to ARM may be risky

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Dear Dr. Don,
I have a 30-year mortgage at 6 percent and have been prepaying $100 a month since November 2003. I was curious about getting a LIBOR adjustable-rate mortgage that resets the payment monthly. Is that a bad idea?

Herbert Highwire

Dear Herbert,
It isn’t necessarily a bad idea, but you need to think through what you’re hoping to get out of the refinancing. Because you would be switching from a fixed-rate mortgage to an adjustable rate mortgage, you’re taking on interest rate risk and will pay more if LIBOR heads higher.

I think of LIBOR, or the London Interbank Offered Rate, as the international equivalent of the federal funds rate. Like the federal funds rate, it’s the rate at which the banks loan reserves out to each other. Also like the federal funds rate, the rate will trend higher or lower based on monetary policy.

The United Kingdom is facing inflationary pressures, just like the U.S. economy. The U.K. places fighting inflation as a higher priority than the Federal Reserve currently does (based on the Fed’s recent decisions). Tightening monetary policy to combat inflation will increase short-term rates like LIBOR.

An ARM that has a monthly reset against the LIBOR rate is priced at a spread to that rate. If the spread is 2.5 percent, adding the spread to the relevant LIBOR rate determines the interest rate on your loan. You can track LIBOR on Bankrate’s ”
LIBOR, other interest rate indexes” page.

With short-term interest rates expected to trend higher over the short-term, you have to ask yourself why you want to leave the certainty of a fixed-rate mortgage at an attractive interest rate to take on the vagaries of an ARM.

The best reason to do it is if you expect your total interest expense will be less with the ARM than it will be with the fixed-rate mortgage. When making this calculation, it’s important to estimate how long you plan to be in the loan and to include the closing costs on the new loan. Try Bankrate’s
fixed vs. adjustable rate mortgage calculator to figure out which is better for you. The Mortgage Professor, Jack Guttentag, also has a
calculator on his Web site that lets you forecast the interest costs of the two mortgages.

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