Can You Refinance into an ARM Loan?

For existing homeowners and first-time home buyers, there are plenty of mortgage options to choose from. Depending on what your home-ownership goals are, there might be an ideal loan choice for your situation. With interest rates changing, make sure you understand what choices you have available so you can go with an option that best fits your financial goals.

What is an Adjustable-Rate Mortgage Loan?

Also known as variable-rate mortgages or floating mortgages, an adjustable-rate mortgage (ARM) loan is one where the interest rate changes periodically based on the market. After a set period, the rate adjusts at regular intervals depending on the details of the loan.

Borrowers will use an adjustable-rate mortgage loan if mortgage rates are high, and there’s a possibility of them going down in a year or so. That way they can secure a loan to purchase a house when they need it and take advantage of interest rates dropping.

Having an adjustable-rate loan means that mortgage payments can be unpredictable when the rate begins to adjust. Depending on interest rates, your payment can increase or decrease.

Types of ARM Loans

ARM loans are broken down into three parts: the fixed-rate term of the loan, the total term of the loan, and how frequently the rate is adjusted.

• Fixed-Rate Term: the period when the interest rate of the loan will not change.
• Total Term: the total length of the loan agreement. If you take out a 30-year ARM loan, the total term is 30 years.
• Rate Adjustment Frequency: how often the rate will change.

Typically, you’ll see ARM loans appear as 3/1 or 5/1. These are indicators on how long the fixed-rate term is and how often the rate can adjust after the fixed-rate term. If the first number is 3, then that means the fixed-rate period is 3 years. If we’re dealing with a 30-year mortgage, then we know there’s a 3-year fixed-rate period, and the remaining 27 years will be an adjustable-rate period.

After that number, you’ll commonly see a 1 or a 6. A 1 means, after the fixed-rate period, the rate of the loan will adjust every 1 year. If the number is a 6, that means the rate will adjust every 6 months.

ARM loans commonly start out with the fixed-rate period when the rate will not change. After that, the adjustable-rate period starts, and the rate will change based on the frequency and the benchmark index tied to the ARM loan. The benchmark index is based on what’s happening with the U.S. economy and how centralized banks like the Federal Reserve are responding to trends.

Hybrid ARM Loan

The most common ARM loan is the hybrid loan, which is broken down into fixed-rate and adjustable-rate terms. The borrower starts out with the fixed-rate period and then moves into the adjustable-rate period where the rate changes at set intervals.

Interest-Only ARM Loan

Instead of paying principal and interest together monthly, an interest-only ARM loan allows the borrower to only pay the interest for a certain period. After which, the borrower is responsible for paying off the loan by the end of the term, which can substantially increase the monthly payments.

Because you’re not adding equity into your home during the interest-only period, the home’s value is completely dependent on home-price appreciation. This can make refinancing during the interest-only period very difficult and is why interest-only ARM loans are considered very risky.

Payment-Option ARM Loan

An option or payment-option ARM loan allows the borrower to select from various payment options each month.

• Principal and Interest: payments include both principal and interest, which reduces the amount owed on the mortgage.
• Interest-only: payments are only applied to the interest, which does not reduce the amount owed on the mortgage.
• Minimum Payment: does not cover the total interest and whatever is not paid will be added to your principal, increasing the debt you owe.

While this offers borrowers flexibility, it also adds a lot of risk to the mortgage loan.

How are ARM Loan Rates Determined?

Mortgage interest rates are determined by three factors:

• Index: a reflection of the overall economy determined Constant Maturity Treasury (CMT) rate.
• Margins: percentage points added to the index by the financial institution the borrower uses. These can vary, so it’s good to shop around for the lowest one.
• Rate Caps: prevent rates from going too high and causing monthly payments to dramatically increase. The different caps are outlined below.

To calculate the exact interest rate, you take the margin and add it to the index. If the index is set to 4.50 and the margin from the lender is 3%, the interest rate is 7.50%. This is why it’s important to find a lender with the lowest margin available.

ARM Loan Rate Caps

To manage expectations, a rate cap is set to limit the amount by which that rate can change, which affects how much the monthly payments can change. The rate cap is represented by 3 limits:

• Initial Adjustment Cap: limits how much the interest rate can adjust after the fixed period.
• Subsequent Adjustment Cap: limits how much the interest rate can adjust in each adjustment period after the first one.
• Lifetime Adjustment Cap: limits how much the interest rate can rise over the life of the loan.

What is a Fixed-Rate Mortgage?

Another type of mortgage loan is a fixed-rate mortgage loan. The interest rate and the principal and interest payment remain the same throughout the entire term of the loan. So, monthly payments are stable, predictable, and shielded from changing market conditions.

Reasons You Should Consider Refinancing into an ARM Loan

One of the most common reasons borrowers choose an ARM loan is because mortgage interest rates are too high but show signs that they’ll be decreasing in the next year or so. If you don’t want to lock yourself into a fixed-rate mortgage while rates are high, an ARM loan will adjust when the market adjusts. It also saves you the hassle of refinancing since you’re already getting the best rate when interest rates decrease.

If you’re looking for a short-term home, an ARM loan allows borrowers to lock in a lower, initial rate early, which can help build equity, and then find another home before the adjustment-rate period begins.

The lower, initial rate also gives borrowers an opportunity to add more to principal early in the loan’s term or invest in other financial goals.

Before agreeing to an ARM loan, make sure you evaluate the risks of potential payment increases during the adjustment-rate period.

How to Refinance into an ARM Loan

If you’re stuck with a high-interest, fixed-rate mortgage loan and the possibility of interest rates dropping is keeping you up at night, there is the option to refinance into an ARM loan.

Like the steps you took to secure the original mortgage loan, you’ll want to shop for the best terms and compare offers from competing lenders to secure the best deal. Once you find an offer you like and makes financial sense, it’s a matter of going through the loan application process.

Is it Hard to Qualify for an ARM Loan?

Qualifying for an ARM loan is like applying for a traditional, fixed-rate mortgage, with a few differences that can make it slightly more difficult. ARM loans require a 5% down payment, while FHA ARM loans require only a 3.5% down payment.

Before applying, you’ll want to assess your current financial situation with your credit score and measure your debt-to-income ratio. Typically, a credit score of 620 is good enough, but some financial institutions may require something higher. And your debt-to-income ratio should be around 50% or less, but this also can vary between lenders and your credit score.

Make sure you’re able to provide proof of income and employment with documents like W-2s, pay stubs, or tax returns. Sometimes additional asset information is necessary, which includes bank account statements, 401k plans, and other investments.

Can You Refinance into a Fixed-Rate Mortgage?

Refinancing is a common way to switch from an ARM loan into a fixed-rate mortgage loan. Homeowners take advantage of this tactic when they’re in their long-term home and interest rates are low. This lets borrowers add stability to their loans by locking in a constant rate when the time is right.

Keep in mind that refinancing means being responsible for all new closing costs and potential penalties. Discuss any plans to refinance with your lender to better understand the cost of refinancing and if it makes financial sense to switch to a fixed-rate mortgage.

Conclusion

Deciding to finance or refinance with an ARM loan involves balancing the attractive lower initial rates against the potential risks of future payment fluctuations. If you still have questions about which loan option best suits your financial situation, talk to us at Community First Credit Union, and we’ll walk you through the available mortgage options to help you can make an informed decision.