Is your adjustable rate mortgage (ARM) about to reset in 2018? You may want to consider other options this year. At current rates, today’s ARMs will probably reset in the mid 4s, which is considerably higher than just six months ago. Before 2016 or so, it may have been better to have an ARM, but these days, it is looking as if rates are going higher for the near future.
If in the past you have ridden your adjustable rate mortgage through the adjustments, you have had low rates. But the economy is improving, tax cuts are taking hold and the Fed is raising rates this year. So, rates are probably on an upward trajectory. You may want to consider either a new ARM or even a fixed rate mortgage with your bank.
How an ARM Works
An Arm is a mortgage for which the rate can adjust based upon current market conditions. In some cases, an ARM can go up, but it also can go down. ARMs can be a great option for the first-time buyer in some situations. For example, if you buy a first home in your mid-20s, you may have a lower salary today, but after five or seven years, your salary could be higher. In that case, you might look at a five-year ARM. You enjoy a low rate now and have a higher rate later when you are making more money.
However, rates on ARMs can go up. They have a higher financial risk that are not part of fixed rate loans. For instance, when you use the ARM to finance your house, you cannot know for sure what your rate will be in 10 years. There is a cap on the rate, but that tends to be quite high, sometimes as much as 9% or 10%.
From 2003 until 2015, almost everyone who had an ARM in the US had their ARM adjust below the rate you could get on a new loan. But that streak was over in late 2015. The Fed raised the Fed Funds Rate and rates on ARMs went up.
Here is how an ARM adjustment works:
- For three, five, or seven years, your rate on the loan is the same.
- When that fixed period is over, the rate will adjust according to the preset formula in your loan documents.
- Once per year after that, the rate will adjust per that formula.
The formula is quite simple. The new rate for your ARM will be the sum of a market rate, such as the 12-month LIBOR, and a profit margin set by the bank, usually 2% or 2.25%. When you add the constant and the variable, you get your new rate.
Depending upon what the current rates are, you may end up with a higher rate. In mid-2017, a typical arm would have reset for about 3.95%, which is quite good. But it was a higher rate than you could obtain with a new five-year ARM. In September 2017, five-year arms were 3.2%. But you have to pay closing costs if you do a new loan.
If you let that loan adjust, you would go to 3.95%, but you would have been paying closing costs. Also, an adjusting loan has no underwriting, credit checks or income verification. You don’t even need to have a job. So, there are valid reasons to allow an adjustment. But you might consider a refinance too.
Refinance to a Fixed?
If the current loan you have is an ARM and is adjusting, you may want to refinance. You can refinance into a new ARM, or refinance to a fixed rate loan. If you allow the ARM to adjust, as we said before, you will get a new rate based upon today’s LIBOR, usually. You also can refinance into a new ARM and lock your rate for five or seven years at a lower rate probably. But you pay closing costs.
Last, you can get a fixed rate loan. After several years of an ARM, many homeowners want to have the certainty of a fixed rate mortgage. Statistics show that 66% of ARM holders get a fixed rate loan when their ARM adjusts. This could be a good fit if you think you will stay in the home for years longer. Also, an improving economy will increase the LIBOR rate and will make your ARM go up. A fixed rate loan is fixed for the life of the loan. But a fixed rate loan is about 1% higher than an ARM. Your stable payment is going to cost you more.
To decide what to do, ask yourself how long you plan to keep your loan. Also, what will your new ARM rate be. Will you be able to save on interest if you refinance? And can you sleep every night without having a fixed rate?
If you are troubled by an ARM, you should have a fixed rate loan. If you think you will sell in a few years, you might be better off with an ARM and a lower rate. Who cares what it readjusts to if you plan to move before it happens?
References: The Mortgage Report on ARMs