Evaluating a Fixed Rate vs ARM Refinance

Evaluating a Fixed Rate or Adjustable Rate Mortgage

One of the most important decisions a home owner will need to make when deciding to refinance their home is whether they want to refinance with a fixed mortgage, an adjustable rate mortgage (ARM) or a hybrid loan which combines the two options. The names are pretty much self explanatory except for the hybrid or Option ARM.  Basically a fixed rate mortgage is a mortgage where the interest rate remains constant and an ARM is a mortgage where the interest rate varies. The amount the interest rate can vary is usually tied to an index such as the LIBOR or Prime Money Rate index.  Usually there are clauses in the loan documents that prevent the interest rate from rising or dropping dramatically during a specific period of time. This safety clause provides SOME protection for both the homeowner and the lender.

However, the massive number of foreclosures we are seeing are mostly due to interest rates on adjustable rate mortgages resetting higher.  In some cases this is causing a homeowners monthly mortgage payments to go up anywhere from 20% to almost doubling.

Advantages of a Fixed Option

A fixed rate refinancing option is ideal for homeowners with good credit who are able to lock in a favorable interest rate. For these homeowners the interest rate they are able to retain makes it worthwhile for the homeowner to refinance at the new interest rate. The major advantage to this type of refinancing options is stability. Homeowners who refinance with a fixed mortgage rate do not have to be concerned about how their payments may vary during the course of the loan period.

Disadvantages of a Fixed Option

Although the ability to lock in a favorable interest rate is an advantage it can also be considered a disadvantage. This is because homeowners who refinance to obtain a favorable interest rate will not be able to take advantage of subsequent interest rate drops unless they refinance again in the future. This will result in the homeowner incurring additional closing costs when they refinance again.

Advantages of an ARM

An ARM refinance option is favorable in situations where the interest rate is expected to drop in the near future. Homeowners who are skilled at predicting trends in the economy and interest rates may consider refinancing with an ARM if they expect the rates to drop during the course of the loan period. However, interest rates are tied to a number of different factors and may rise unexpectedly at any time despite the predictions by industry experts.

A homeowner who can predict the future would be able to determine whether or not an ARM is the best refinancing option. However, since this is not possible homeowners have to either rely on their instincts and hope for the best or select a less risky option such as a fixed interest rate.

Disadvantages of an ARM

The most obvious disadvantage to an ARM refinancing option is that the interest rate may rise significantly and unexpectedly. In these situations the homeowner may suddenly find themselves paying significantly more each month to compensate for the higher interest rates. While this is a disadvantage, there are some elements of protection for both the homeowner and the lender. This often comes in the form of a clause in the terms of the contract which prevents the interest rate from being raised or lowered by a certain percentage over a specific period of time.

Consider a Hybrid Refinancing Option

Homeowners who are undecided and find certain aspects of fixed rate mortgages as well as certain aspects of ARMs to be appealing might consider a hybrid refinancing option. A hybrid loans is one which combines both fixed interest rates and adjustable interest rates. This is often done by offering a fixed interest rate for an introductory period and then converting the mortgage to an ARM. In this option, lenders typically offer introductory interest rates which are extremely enticing to encourage homeowners to choose this option. A hybrid loan may also work in the opposite way by offering an ARM for a certain amount of time and then converting the mortgage to a fixed rate mortgage. This version can be quite risky as the homeowner may find the interest rates at the conclusion of the introductory period are not favorable to the homeowner.

Copyright 2007 Mark V. Schwartz - All Rights Reserved

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