Should You Ever Refinance Into an Adjustable Rate Mortgage?

It seems unwise on the surface: refinancing from a stable fixed-rate loan into an adjustable-rate mortgage (ARM).

But sometimes it makes perfect sense.

Here’s when you should consider refinancing a fixed mortgage to an ARM.

Don’t Overpay For a Fixed Rate

Most people “overpay” for the security of a 30-year fixed mortgage. The majority of borrowers hold their loans less than 10 years.

Yet, the idea of a cheaper loan that is fixed for five or seven years scares them.

When rates are low, it makes sense to lock in a fixed rate.

But when rates are high, the average refinancing homeowner should at least consider an ARM as they shop.

When to Consider an ARM Refinance

Plenty of life circumstances could make an ARM attractive.

• You plan to sell the home within five years

• You will pay off the mortgage soon

• You plan to pay down the balance significantly

• You expect to have a higher income within a few years

• You must refinance again within five years

But the best time to get an ARM is when you expect rates to drop in the future.

The Best Time To Get Into an ARM is Now

The best time to get into an ARM is when rates are high, but not for obvious reasons.

Yes, you can get a lower rate and payment compared to fixed loans. But a better reason is that your rate has a better chance of going down in the future, not up.

Most people associate ARMs with ballooning payments and eventual foreclosure. This reputation is a byproduct of the early 2000s when people received ARMs – many with risky features not found today – only to be stuck with huge payments later.

But people forget that ARM rates can drop, too.

After the initial fixed period, often five years, the loan starts adjusting based on its index. The index is typically the Secured Overnight Financing Rate (SOFR) currently at its highest point since its creation in 2020.

The Fed is working to fight inflation and is expected to cut its key interest rate in 2024. All signs point to a dropping SOFR as time goes on.

By 2029 when your ARM rate starts adjusting, the SOFR could be significantly lower. In fact, the SOFR 30-day average is already showing signs of breaking. It's down from an all-time high near 5.35% in early January to 5.33% later that month.

ARM Rates Can Drop, No Refinance Required

A dropping SOFR can benefit you because it can save you thousands of dollars in refinance costs someday.

As an ARM index decreases, your rate adjusts downward if you’re in the adjustable period (typically years six through 30).

For example, you get a 5-year ARM today at 6% that's based on the SOFR.

If the loan started adjusting today, your rate would be 8.08% (the current 5.33% SOFR plus the 2.75% margin.) Luckily, you’re still in the fixed period so you pay 6%.

But what happens if the SOFR drops to 2% during the adjustable period, where similar indexes have tracked prior to 2019? You would have a rate below 5%.

*Example purposes only. Not meant to be a prediction. **This would not be your rate today, since you would be locked in for five years at the introductory rate.

Keep in mind that you don’t have to spend thousands in refinance costs to receive the lower rates. Your loan automatically adjusts downward if the index drops.

What if My Rate Rises?

There’s a chance your rate could rise. It’s not guaranteed that the SOFR or any other index will fall during your adjustable period.

But ARMs come with borrower protections. They limit how far and fast the rate can rise.

These protections are called “caps."

Freddie Mac imposes 2/1/5 caps for its 5-year ARMs. This means the loan can’t rise more than 2% at the first adjustment, 1% at each subsequent adjustment, and no more than 5% at any time.

For example, if you received a 5-year ARM at 6% today,

• It could not rise above 8% at year six

• It could not rise more than 1% every six months at any adjustment

• It could never exceed 11%

While rates could potentially rise in the future, your payment will rise gradually. In the above example, a $350,000 loan would rise about $450 per month assuming the maximum 2% increase in year six.

Gone are the days of mortgage payments doubling due to shady lending practices.

Don’t Overpay for Your Mortgage

Mortgage rates are expected to drop in coming years. It could make sense to capitalize on automatic rate reductions via an ARM refinance.

Speak with a lender and compare ARM rates before deciding on a fixed mortgage.