What to Watch Out for When Refinancing to an ARM
Introduction
Refinancing a mortgage can be a great way to save money on your monthly payments, but it's important to understand all of your options and the potential risks involved.
One option that some homeowners consider is refinancing to an adjustable-rate mortgage (ARM). While ARMs can offer lower initial interest rates, they come with the risk of future rate hikes that could increase your monthly payments.
What is an ARM?
An ARM is a type of mortgage where the interest rate can change over time. Typically, ARMs start with a lower interest rate than fixed-rate mortgages, but that rate can increase or decrease based on the performance of an index, such as the prime rate.
Most ARMs have an initial fixed rate period, usually lasting anywhere from 1 to 10 years, where the interest rate remains the same. After this period, the rate will adjust annually, which could result in higher or lower payments.
Benefits of Refinancing to an ARM
- Lower initial interest rates: ARMs typically start with lower rates than fixed-rate mortgages, which can save you money on your monthly payments in the short term.
- Ability to take advantage of falling interest rates: If interest rates drop, your ARM rate may drop as well, which could further lower your monthly payment.
- May be a good option for short-term homeowners: If you don't plan on staying in your home for more than a few years, an ARM may be a good option since you'll enjoy lower initial payments before you sell or refinance.
Risks of Refinancing to an ARM
- Potential for higher payments in the future: Once your ARM rate starts adjusting, your monthly payments could increase significantly, and there's no way to predict how high they could go.
- May be a bad option for long-term homeowners: If you plan to stay in your home for many years, an ARM may not be the best choice since you could be exposed to future rate hikes that would make your payments unaffordable.
- Complexity: Since ARMs are more complex than fixed-rate mortgages, they can be harder to understand and may require more financial planning.
When is an ARM a Good Option?
Refinancing to an ARM may be a good option if:
- You plan on staying in your home for a short period of time, generally 3-5 years.
- You're comfortable taking on the risk of rising interest rates in exchange for lower initial payments.
- You can afford potential future payment increases or plan to refinance before your rate adjusts.
If you're considering refinancing to an ARM, there are several things to watch out for:
- Teaser rates: Some lenders may offer very low rates to attract borrowers, but these rates will only last for a short period of time before the rate adjusts.
- Caps: ARMs have caps on how much the rate can adjust each year or over the life of the loan. Check to make sure you understand and can afford the potential rate hikes.
- Prepayment penalties: Some mortgages, including ARMs, may have penalties if you pay off the loan early. Make sure you understand these penalties before refinancing.
- Future plans: Make sure you consider your future plans, such as moving or retiring, since these could impact your ability to afford future rate hikes or refinance.
Conclusion
Refinancing to an ARM can be a good option for some homeowners, but it's important to understand all of the potential risks and weigh them against the benefits. Make sure you do your research and consult with a financial advisor or mortgage professional before making a decision.