Should you refinance your ARM into a fixed-rate mortgage?

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With average mortgage rates dipping in the midst of the COVID-19 pandemic, adjustable-rate mortgage borrowers may be thinking about refinancing to a fixed-rate mortgage.

The average 30-year fixed mortgage rate, as well as ARM rates, are at historic lows, but, if you have an ARM and you’re nearing the end of your term, you could see a spike. That’s because ARM interest rates readjust based on an index plus a margin. Common indices include the maturity yield on one-year Treasury bills, the 11th District Cost of Funds Index and the London Interbank Offered Rate (Libor). If the index your ARM tracks has an interest rate of 1 percent, for example, and your lender’s margin on ARMs is 2 percentage points, your rate would adjust to 3 percent when the current term is up. (Note: Libor may be phased out by the end of 2020, so your ARM may soon track another index that might behave very differently.)

Moreover, some lenders have high caps on how much your interest rate can increase by. You can find the caps in your closing documents, or contact your lender for more information.

But with a fixed mortgage, there’s no guessing involved — your monthly payment will remain the same for the life of the loan. This is especially beneficial during uncertain times, when you may be unsure about your income.

“The idea of trading away the uncertainty of an adjustable-rate mortgage for the certainty of a fixed-rate mortgage is appealing,” explains Bankrate Chief Financial Analyst Greg McBride, “especially if you’re expecting an adjustment in the next year or two.”

Of course, fixed mortgage rates can drop even lower, but you may not benefit if you wait.

“By taking advantage of historically low rates and locking it in for a longer term, you de-risk an interest rate step-up, which would increase your monthly payments,” explains Glenn Brunker, a mortgage executive with Ally. “You may not have the financial means to make that escalated payment.”

McBride also advises acting with caution.

“A situation you don’t want to be in is one where your income doesn’t change much, but your mortgage payment increases,” McBride says.

Should you refinance your ARM into a fixed-rate mortgage?

If current mortgage rates are significantly lower than the rate you’re paying now and you’re nearing the end of the initial term on your ARM, you might consider refinancing into a fixed-rate mortgage.

These conditions shouldn’t be the sole deciding factors, however. Remember, when you refinance, you’re taking out a new loan, which involves closing costs. One way you can determine whether you’re truly benefiting from a refinance is to divide the costs by the savings. This indicates how long you need to stay in your home before you recoup those costs. For example, if you’re saving $100 on your monthly mortgage payment by refinancing, and your closing costs are $2,000, it will take you 20 months, or close to two years, before you really start seeing savings.

“The general rule of thumb is that if you can lower your rate by at least one percentage point, you can quickly recover the cost of refinancing,” says Austin Kilgore, director of Digital Lending, Javelin Strategy & Research.

Refinancing also may not be the best move if you plan to move out of your home relatively soon.

“If you’re only looking at being at home for three or four more years and you have four years before it resets, and a new loan is not at least three-eighths of a basis point lower than your current rate, you might as well stay in your ARM,” says Ralph DiBugnara, president of Home Qualified. “There’s no financial benefit to move forward into a fixed rate.”

Refinancing your ARM during COVID-19

If you decide to refinance your ARM into a fixed-rate mortgage, keep in mind that many more people are refinancing now — and the demand is putting pressure on some lenders, especially ones with smaller staff who are working from home.

“Our refinance business has surged and it’s close to 85 percent of our production,” Brunker says. “The industry as a whole has slanted heavily toward refinance.”

If you’re exploring the option of a refinance today, consider the following steps.

Clean up your credit

With millions of people out of work, lenders may be hesitant to approve loans for folks with less-than-favorable credit. A recent study by the Urban Institute shows the rate gap is widening between higher- and lower-credit score borrowers, and those with scores above 720 were able to obtain mortgage rates 78 basis points lower than those with scores below 660. This difference matters, because your interest rate affects your monthly mortgage payment.

For example, if you’re buying a $200,000 home with a 20 percent down payment ($40,000) and a 3 percent interest rate on a 30-year mortgage, your monthly mortgage payment would be $674, excluding homeowners insurance, property taxes and other costs. As your interest rate rises, however, your payment will, too.

Home Price Down Payment Loan Term Interest Rate Monthly Mortgage Payment
$200,000 20% 30 years 3.00% $674
$200,000 20% 30 years 3.78% $743
$200,000 20% 30 years 5.00% $858

So, it may be best to improve your credit before you pursue refinancing. This is especially important during times when it’s harder to qualify for a loan.

“We’re seeing some lenders start to position relatively tighter underwriting guidelines,” Brunker says. “If COVID-19 has a stronger economic impact than anticipated in the market, we may see lenders pull back and require lower LTVs and stricter credit score requirements.”

However, if you’ve been making timely payments, your discipline may be rewarded.

“Someone coming up on the end of an ARM presumably has five or more years of timely mortgage payments on their credit history,” explains Kilgore. “There’s a good chance their credit score is better now and they may qualify for something better.”

Compare refinance rates

When looking to refinance, it’s important to shop around and compare rates online. If you’ve established a relationship with your current lender, you may get a favorable rate, but that doesn’t mean another lender won’t be willing to offer you a better rate. Be sure to compare the fees and terms in order to see how much you’d truly be saving across different lenders.

You might also consider consulting with a mortgage broker. Some have relationships with specific lenders and can offer rates that you may not get directly from those lenders. United Wholesale Mortgage, for instance, recently announced a new program offering qualified borrowers rates as low as 2.5 percent for new mortgages and refinances.

Because the refinancing process can take longer in the pandemic, consider locking your rate, as well. When you lock your rate, your lender guarantees the interest rate for a set time period.

Contact your lender

Ask your lender what their underwriting process is like in these uncertain times. Many have digitized parts of the process in order to reduce contact. For instance, some are allowing electronic signatures and notaries for crucial documents, and you may be allowed to send other materials in electronically, such as in the case of an employer giving you digital access to your W-2.

Those that have shied away from digitizing, however, may take longer to finalize your refinance.

“Many lenders don’t have digital capability and have more face-to-face contact than they initially had intended,” explains Brunker. “It can take 90 to 120 days to close with a surge in refinance.”

Other parties involved in closing a refinance, such as appraisers, are also limited in their abilities due to COVID-19, but there are flexibilities. For example, Fannie Mae and Freddie Mac, which back most mortgages in the U.S., are allowing exterior and computer-based appraisals, and in certain cases, even waiving the need for appraisals. Be sure to ask your lender how the appraisal process would be conducted, if at all, at this time.

Bottom line

Consider refinancing your ARM into a fixed-rate mortgage if you’re close to the end of your term and current interest rates are lower than what you’re tied to. This will lower your monthly payments and steer you away from potentially higher interest rates down the road.

Be sure to factor the total costs of refinancing, including closing costs, and keep in mind that unless your refinance rate is considerably lower than your current rate, you won’t be saving much. You may even end up paying more over the life of the loan, especially if you’re refinancing into a longer-term mortgage. You can use Bankrate’s refinance calculator to figure out the real cost of refinancing.

If you’ve calculated the costs and decided refinancing your ARM into a fixed-rate mortgage is right for you, ensure your credit is in the best shape possible, and compare rates. In addition, ask your lender about how they’re conducting business in the pandemic — there could be delays due to demand or other factors to consider at this time.

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