Refinancing Adjustable Rate Mortgage Loans
The most basic explanation of an adjustable rate mortgage (ARM) loan is in its name, it is a loan in which the rate adjusts or changes. A fixed loan maintains the same interest rate through the life of the loan. ARM loans generally begin with a low rate which means a lower payment but chances are most ARM mortgages will convert to a higher payment. We mention this because at Nations Lending we do lots of both kinds of loans.
Our originators often work through an example of the math on an ARM loan. A client has a 5/1 ARM: 5/1 represents a fixed rate for 5 years and then will adjust every year after. After the 5-years has elapsed, the new rate will be based on the 1 Month LIBOR plus 2.25% (the 2.25% is referred to as the margin, LIBOR is an acronym for London Interbank Offered Rate). It has an adjustment that cannot be greater than 2% higher than the rate the year before.
Continuing with this example, let’s say your loan rate is currently last year’s LIBOR, 0.17%, plus your margin of 2.25% for a rate of 2.42%. The next annual adjustment is based on LIBOR which has increased to 0.44%, so your rate for the next year will be 2.69%. With the maximum rate increase of 2%, the highest your rate can be the following year is 4.69%. This is the on-going process your payments will follow throughout the duration of your loan.
One way to analyze the facts is to approach the conversion from adjustable to fixed rate as you would with insurance. How much more in premium are you willing to pay for how much more coverage should you need the insurance? There is a cost-benefit analysis that has a very big unknown, in this case, when, how fast and for how long will rates move up forcing you into increasing payments on your home?
In the end, it comes down with your comfort level of unknown future payments and what your tolerance is for higher payments. Be sure to talk to a Nations Lending expert!