So, you have an adjustable rate mortgage, what to do, what to do?
A lot of consumers took advantage of low mortgage rates five years ago by taking out an adjustable rate mortgage. These mortgage loans, generally fixed for 3 years or 5 years, 7 years or 10 years, allowed consumers to save thousands of dollars in interest by having an interest rate below the rate of a fixed rate mortgage.
For example, on a $300,000 mortgage, in November of 2004, you could get a 5/1 ARM (principle and interest payments) at 4.5%. The comparable 30 year fixed rate loan at the time was around 5.375%, giving the adjustable rate mortgage a monthly savings of $159 per month . . . or $9,540 over the first 60 months (5 years fixed term). Saving $10,000 is good, not toxic, or exotic, or evil as the media has vilified ARMs; a $10,000 savings is a good thing. In fact, in 2004, Alan Greenspan agreed that savings thousands of dollars is a good thing, stating that ”American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.” (source: usaToday.com here).
My prediction — the NEXT big headline against the mortgage industry (give it 12 to 24 months to materialize) will deal with consumers with ARM’s NOT refinancing to fixed rate mortgage when rates were at an all time historic low (ala, now). The media will likely talk about how confused consumers, not fully understanding the terms of their risky exotic mortgage . . . (breathe, 1, 2, 3 . . . more on that next time).
So, for any consumer who HAS recently refinanced their ARM in to a fixed rate mortgage, EVEN if you spent $6,000 in closing costs to refinance, you have still saved $3,540 when compared to the 5.375% fixed rate mortgage you could have started with. And, in addition to that savings, you now have a rate in the high 4’s, where if you would have still have had the 5.375%, you may have just kept it, because the difference between the two is probably not enough to warrant the refinance (an additional $115 in savings per month).
So why are consumers NOT refinancing out of their ARMs in to historically low fixed rate mortgages?? For some it is because they can not refinance their mortgage (low appraised values, loss of income, 2nd mortgage unwilling to subordinate). But for others, it is because their interest rate has actually gone DOWN.
Continuing with the example above, with a start rate at 4.5% in November of 2004 (lets also assume the ARM in the example is based on the LIBOR index with a 2.25% margin) . . . in November of 2009 at the time of adjustment, the LIBOR index was around 1.95%, which means that the interest rate would adjust to (index + margin), 1.95% + 2.25% = 4.25%. Assuming this loan is a standard conventional principal and interest ARM, the rate of 4.25% would now be fixed for 12 months, and the payment would go down by $45 per month . . . even more savings! If your interest rate were to adjust today (February 2010), because the LIBOR index is even lower, the rate would adjust down to 3.25%!
And WHY IN THE WORLD would anyone pay $6,000 in closing costs to refinance out of a 3.25% interest rate??
1 — Historically low rates will (will) [will] (will) come to an end. Economist agree that interest rates WILL go up — how quickly and how high is certainly up for discussion. The Feds program to purchase mortgage -backed securities (MBS) is ending March 2010 (next month) and supply and demand tells us that rates will go up. The Feds are providing the demand for purchasing MBS, with them stepping out, the demand will go down, prices will go down, and when prices go down, mortgage rates go UP.
The Feds announced their MBS purchase program in November 2008 and look what happened to rates immediately.
2 — Your next adjustment will be UP (very likely).
Most people assume that when the Feds “raise rates” that mortgage interest rates go up. While this is sometimes true, the Feds actually move an internal banking rate known as the Federal Funding rate. While the Fed’s Fund rate is not tied directly to mortgage rates, it does track with the LIBOR index. And as the Feds “raise rates” the LIBOR index will follow. The 5 year average for the 12 month LIBOR index is 3.9. Using this as an assumption of where it might stand a year from now, 3.9% index + 2.25% margin = 6.15%. Taking the scenario above, and your payment from 3.25% to 6.125% just went UP more than $500 per month!
3 — Refinancing now is better than refinancing later (likely).
Instead of an increase of $500 per month (3.25% to 6.125%), that $300,000 mortgage could be refinanced at 4.75% = an increase in payment of $260 per month from 3.25%, but a savings of $257 when compared to 6.125%. Assuming the closing costs are $6,000 to refinance now, and assuming that the following year (2011) the ARM would stay around the 6.125% (which may be the BEST case scenario), the closing costs on a new refinance would take 23 months to recoup. Which means, assuming that you are going to stay in your current home for more than 2 years from today, you should refinance . . . you should refinance, now . . . unless you think interest rates will go lower . . . which they aren’t . . . so you shouldn’t think . . . so you should . . . refinance.