Adjustable-rate mortgage loans grew more popular in 2022 thanks to a record surge in mortgage rates. Favorable short-term introductory rates can make ARMs an attractive option for some homebuyers. While this type of mortgage can be appealing to those hoping to save some money upfront, it can cost more in the long run if you’re not careful.
If you purchased an ARM over the past few years, you may want to consider refinancing it into a fixed-rate mortgage. With mortgage rates decreasing and the Federal Reserve cutting rates, it may be a good time to refinance and lock in a low fixed-rate.
Here’s what to think about while you consider refinancing.
[Read: Best Adjustable-Rate Mortgage Lenders.]
Can You Refinance an ARM to a Fixed-Rate Mortgage?
ARMs may be appealing upfront, but “the glitz of lower payments can suddenly lose its glamour after the grace period ends and a new period of higher payments begins,” says Jodi Hall, president of Nationwide Mortgage Bankers.
Homeowners can refinance their ARM to a fixed-rate mortgage at any time. In the right scenario, you could secure an interest rate that’s about the same or even lower than what you’re currently paying.
With a fixed-rate mortgage, your interest rate remains the same for the life of your loan. This predictability and simplicity make it the more popular type of mortgage by far.
With an ARM, your interest rate remains fixed for a certain period — typically three, five or 10 years — after which it switches to a variable rate that adjusts every six or 12 months. These are called hybrid ARMs. There are also other types of ARMs, such as interest-only and payment-option ARMs.
Refinancing into a fixed-rate mortgage “provides stability in the form of fixed expenses, which allows individuals to feel more secure with changes in personal planning, such as retirement,” Klein says Deb Klein, branch manager at Reliability in Lending at Primary Residential Mortgage.
[Read: Best Mortgage Refinance Lenders.]
Why Refinance an ARM
What all ARMs have in common is an initial fixed-rate period and then a longer adjustable-rate period. That arrangement shifts the risk of rising interest rates from the lender to the borrower. If rates rise after the initial fixed-rate period, borrowers could end up paying a lot more in interest for the rest of the mortgage term.
One way to mitigate that risk is by refinancing from an ARM to a fixed-rate loan.
ARMs start with lower interest rates than fixed-rate mortgages, but can shoot up when the adjustable-rate period stats. When mortgage rates are low, the gap gets smaller.
The average rate on September 26, 2024, for a 5/1 ARM — a loan with a five-year fixed period and then a rate that adjusts annually — was 6.06%. Meanwhile, the 30-year fixed-rate mortgage average was 6.11%.
When rates are this close, refinancing to a fixed rate mortgage could help secure lower payments for a longer term. If you’ve already established a budget around your ARM payments, refinancing with a low rate will help keep that expense consistent.
[Calculate: Use Our Free Mortgage Refinance Calculator to Estimate Your Monthly Payments.]
What Are the Risks of ARM Refinance?
Even if your new rate is slightly higher, refinancing into a fixed-rate mortgage will be less risky in the long run. But depending on the situation, there are some potential downsides to consider:
Closing Costs
Every time you take out a mortgage, whether it’s a purchase loan or a refinance loan, you’ll need to pay closing costs. Those can amount to 2% to 6% of the loan amount.
In many cases, you can either pay those costs upfront or roll them into the new loan.
Rolling them into the new loan may sound like a good idea, especially if you don’t have a lot of cash on hand. But over 30 years, $10,000 in closing costs with a 5% interest rate will end up costing you $19,326.
Interest Rate Risk
While you may have gotten an ARM with the plan to refinance before your fixed period is up, an ARM refinance may increase your costs if interest rates have jumped since you took out the loan.
If rates have gone up drastically, it could even make your new loan unaffordable, at which point you may feel forced to hold onto the ARM.
The silver lining in this scenario is that lenders limit how much they can hike an interest rate during each adjustment period and overall. That means you may not immediately have to pay the current market rate.
Still, it gives you less flexibility and can make you feel helpless about your situation.
Prepayment Penalty
Some ARMs may come with a prepayment penalty that kicks in if you refinance your loan or sell your home within three to five years. The penalty may be a fixed amount — such as six months’ worth of interest — or a percentage of your principal balance.
This fee, which can cost thousands of dollars, will be in addition to your closing costs on the new loan.
If you’re planning on applying for an ARM, watch out for such a penalty. And if you’re thinking about refinancing, review your loan agreement for it.
[Read: Best Mortgage Lenders]
When Is the Right Time to Refinance an Adjustable-Rate Mortgage?
As with any major financial decision, consider both the benefits and the drawbacks. With that in mind, here are some situations where it might make sense to refinance your ARM:
— Your credit score is in good shape. If your credit score is as good as or better than when you took out the loan, you’ll have a better chance of getting a comparable or even lower interest rate than what you’re paying now. And in a rising-interest-rate environment with little possibility of lowering your rate, it can still help you maximize your savings on the new loan.
— You’re planning on staying in the home for a long time. If you’re nearing the end of your fixed period and you’re only planning on staying in the home for one or two years, the refinance closing costs may outweigh the increase in your monthly payment if your rate adjusts upward. But if you’re not planning on moving within the next few years, it may be worth it to lock in a fixed interest rate, especially if economic conditions appear murky.
— You can afford the closing costs. It’s generally better to pay closing costs out of pocket than to roll them into the new loan. If you can afford that without putting your emergency fund at risk, and you plan on staying in the home for several years, it may be worth it.
— You have other financial goals. If you’re considering a cash-out refinance to consolidate debt, pay for home renovations or achieve other financial goals, switching to a fixed interest rate at the same time allows you to accomplish two goals at once.
— Interest rates are low, or expected to increase dramatically. If interest rates are already on the rise, you may want to lock in a fixed rate earlier rather than later. That’s the case even if you’re not nearing the end of your fixed period. If interest rates are falling, keep an eye out to see if you can secure an even lower interest rate when refinancing. Do some research on the direction interest rates are going and what experts are saying about their trajectory to decide.
— You’re ready for more security. Even if interest rates are increasing, the future of the market is unpredictable. “If rates fall in the future, you will have refinanced for nothing,” says Hall, “but if they rise, you may have saved yourself tens of thousands of dollars.” If you’d rather have the predictability of a fixed monthly payment instead of the potential for a lower payment in the future, refinancing can give you that peace of mind.
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When Should You Refinance an Adjustable-Rate Mortgage? originally appeared on usnews.com
Update 09/30/24: This story was published at an earlier date and has been updated with new information.
