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Changing course in refinancing: ARMs vs. fixed rates

Posted by  on Sep 30, 2014
 

Refinancing is often presented as an apples-to-apples comparison: For example, if you compare mortgage rates on two 30-year loans and find today's rates are significantly lower, you refinance. However, there are times when the right choice is more of an apples-to-oranges comparison.

It is hard to compare adjustable-rate mortgages (ARMs) and fixed-rate loans directly, because the interest rate you will pay on the ARM over most of the loan's term is an unknown when you start out. These two types of loans represent completely different directions as a borrower, but sometimes it makes sense to change direction.

The following are some examples of when you might want to refinance by switching from a fixed-rate loan to an ARM, and vice versa.

From fixed to adjustable rates

Here are three examples of when you might want to switch from a fixed-rate to an adjustable-rate loan:

  1. The interest rate outlook has changed. Mortgage rate history from the Federal Reserve shows that during the inflationary environment of the early 1980s, 30-year fixed mortgage rates rose as high as 18.45 percent. However, once inflation was brought under control, mortgage rates fell quickly and were in the single digits within five years of hitting that peak. That type of profound economic change is an example of an environment in which one would be wise to switch to an ARM in order to take advantage of falling rates.
  2. Your time frame for repayment has changed. ARMs typically offer a lower interest rate initially, but then this adjusts to market rates as the loan term goes along. However, if you now plan on repaying the loan within a few years, you can capture that lower initial rate without incurring much risk of rising rates in the future.
  3. The interest rate spread has widened. The difference between 30-year fixed rates and the low initial rates offered by ARMs varies; and when this spread is particularly wide, it can somewhat reduce the risk of rising rates in the future -- especially if your ARM has a relatively low reset cap.

From adjustable to fixed rates

Here are three examples of when you might go in the other direction and switch from an ARM to a fixed-rate mortgage:

  1. You want to lock in your mortgage costs for the long term. If payments would be affordable at current fixed rates and you plan to be making those payments for many years, you might want to lock in current rates to make sure your mortgage remains affordable.
  2. Interest rates are historically low. As of mid-2014, 30-year fixed mortgage rates were still among the lowest in history. If you think rates are bound to return to their historical norms eventually, you might want to lock in rates while the low-rate environment is still around.
  3. The spread is not compelling. Just as a wide spread between fixed and adjustable rates can make ARMs more compelling, when that spread tightens up it means there is less of a risk cushion in ARMs.

The risk you incur by switching to an ARM is largely a function of time; so in general, the shorter the time before you expect to repay the loan, the more you can limit that risk.

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