When interest rates go down, it's easy to see why you should refinance. Getting a new mortgage is a good idea if you can save money every month without having to pay a lot of money to refinance.
But what happens when rates go up? In this case, there might not be any money to save each month. In fact, there are times when monthly costs may go up. Does it ever make sense to refinance in a rate environment like the one we're in now?
Even when rates are going up, it would be smart for many borrowers, especially those with "nontraditional" loans from the past few years, to refinance.
Even though interest rates may not be as good as they were when they hit record lows in 2003, refinancing now may be a much better idea than waiting and possibly having to deal with even higher rates in the future.
In what situation am I talking?
Let's look at a borrower who knows for sure that costs will go up in the future, and go up quickly.
You have a mortgage for 30 years. During the first five years, you only have to pay the interest, which is fixed at 5.5%. The loan balance is $300,000, and the first monthly payment for principal and interest is $1,703.37.
In year six, the loan turns into a 1-year ARM. There is still $300,000 to pay back, but the loan term is now only 25 years. Also, interest rates go up in year six. Let's say the new rate is 6.5 percent. In year six, the new payment for principal and interest is $2,025.62 per month.
Why did the cost each month go up so much?
First, during the first five years of the loan term, the original loan balance was not paid down. Because of this, the original loan amount has to be paid back in 25 years instead of 30. Even if the rates stayed the same, a shorter time to pay back the loan means that the monthly costs will be higher.
Second, the rate of interest went up. In our example, the rates went from 5.5% to 6.5%, but they could go even higher. For example, if interest rates reached 8% in year six, which hasn't been unusual in the last 20 years, the monthly cost of principal and interest would be $2,315.45. At 9 percent, the cost would be $2,517.59 per month.
With the possibility of much higher payments and possible increases in other costs like utilities and property taxes, it can make a lot of sense for people with interest-only loans, "option" ARMs, and ARMs in general to switch to fixed-rate loans when rates go up.
Say, for example, that rates are now at 6.5 percent. Our borrower with a $300,000 loan balance will get a mortgage with a fixed rate of 6.5%. Over 30 years, he pays $1,896.20 each month for the loan and interest. Yes, that's more than the current monthly payment of $1,703.37, but what's more important is that the new monthly payment won't go up, which is a big plus when you consider that future costs could put you in debt.
One ARM for the Other?
When rates are expected to go up in the long run, it makes sense to switch from ARMs and non-traditional loans to loans with fixed rates, as shown above. But is it ever a good idea to switch out one ARM for another?
Actually, it does, but only in some ways.
ARMs are appealing for two reasons: their starting interest rates are usually lower than those of fixed-rate loans, and the requirements to qualify for an ARM loan tend to be less strict than those for a fixed-rate loan. This means that borrowers can get bigger loans with an ARM than with a fixed-rate loan.
When it comes to refinancing, there is one reason to think about switching from one ARM to another: Rates and payments on many combo-ARMs and interest-only loans are locked in for the first three, five, or seven years. Compared to a fixed-rate loan, the savings may not be very big, but the requirements to get the loan are likely to be less strict. This means that borrowers who can't get fixed-rate loans and whose monthly costs will soon go up by a lot may be able to get help from another ARM or an interest-only loan.
A substitute combo-ARM or interest-only loan can give you a few years of stable rates and payments. During this time, you may be able to refinance to a lower-cost fixed-rate product or sell the property at a good price.
