Don't Ditch That ARM Just Yet
By: BankingMyWay.com Staff

By BankingMyWay Staff

A rate reset on an adjustable-rate mortgage (ARM) can be stressful. But thanks to historically low interest rates, there's a good chance your rate will actually go down if it’s scheduled to reset in the next few months. If that's the case, you might be better off sticking with your ARM a little longer, despite the low rates on fixed-rate mortgages (FRMs).

Interest rates on ARMs typically are calculated by adding percentage points to a rate index -- most commonly the 12-month London Interbank Offered Rate, or LIBOR. The rate index fluctuates, and the margin between your rate and the rate index is set by the lender and remains fixed for the life of your loan. The margin is often 2.75%, but can be higher if your lender considers you a risky borrower.

The 12-month LIBOR has fluctuated widely over the past decade -- it was at a low of roughly 1% in 2004 before rising steadily to more than 5% by the end of 2007. Now with LIBOR back to the 2% mark, borrowers with ARMs are potentially facing a drop in their interest rates.

For example, say your mortgage rate is scheduled to reset in March, and you're deciding between refinancing with a new FRM and letting your rate reset. Your current interest rate is around 5%, and you have $200,000 remaining on your initial mortgage. The margin on your ARM is 2.75%, so with the 12-month LIBOR roughly 2%, your rate would drop to 4.75%. That means your monthly payments, which are now $1,169, will likely be reduced to $1,140. BankingMyWay.com's ARM calculator can show how your specific numbers might change.

If you choose to refinance with a FRM instead, you could end paying more than $3,000 in closing costs to refinance at a higher interest rate than what your ARM will reset to. For instance, residents of North Carolina can apply for a 30-year FRM with a rate of 5.375% from Bank of America (Stock Quote: BAC), with a rate of 4.8% from SunTrust Bank (Stock Quote: STI), or with a rate of 5.25% from Wells Fargo (Stock Quote: WFC). To see what lenders are offering in your area, look at BankingMyWay’s mortgage section and enter your ZIP code.

Moreover, most ARMs have a cap on how high the rate can jump at each reset point -- usually around 0.5%. So when your rate resets a year from now, it couldn't rise above 5.25%, which is still lower than some of the refinance rates currently available. That means you'll not only save on refinancing costs, but you could have two years of lower payments compared to a new FRM. The longer you hold your ARM, however, the likelier it is that your rate will rise higher than current rates of FRMs.

So if you're planning on living in your home for many years, locking in a low fixed-rate now might be your best bet. But refinancing just to avoid a rate reset is not necessarily the right decision.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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