April 4 , 2005, Rewritten August 7, 2006, Revised September 29, 2006

A borrower with an ARM may want to refinance into an FRM in order to lower costs, stabilize payments, or some combination of the two.

Information Needed For the Decision

To properly assess this decision, the borrower needs 4 pieces of information: 1) The current rate on the ARM; 2) The period until the next ARM rate adjustment; 3) The current fully-indexed rate on the ARM; and 4) The rate and other terms on the FRMs available in the current market.

Most borrowers know the ARM rate they are currently paying and when the rate will adjust, but few know the fully-indexed rate (FIR). This is the most current value of the interest rate index used by the ARM, plus the margin. The index used and the margin are both shown in the note, while the current value of the index is easily available on-line. Go to http://www.mortgage-x.com/general/mortgage_indexes.asp, it has them all.

The importance of the FIR is that it is the best available predictor of how your ARM rate will change. At the next adjustment date, the new ARM rate will reset to equal the index value at that time, plus the margin. [Note: usually there is a limit on the size of a rate change – this “rate adjustment cap” can also be found in the note -- but in today’s market the limit is seldom relevant]. If the index stays unchanged between now and then, the ARM rate at the next adjustment will be today’s FIR.

This generalization has to be modified slightly for 4 indexes: COFI, CODI, COSI and MTA. Because these indexes lag the market, the best estimate of what they will be when your ARM rate is adjusted is their projected value 12 months ahead, not their value today. The mortgage-x site referred to above provides such projections for you.

The relevant FRM rate is the one you can command in today’s market without incurring any refinance costs. Shop for a no-cost refinance at one of the Upfront Mortgage Lenders.

Some Borrowers Should Refinance, Some Shouldn’t: A Classification

Borrowers with an ARM can find themselves in any of 4 possible situations:

Both the ARM Rate and the FIR Are Higher Than the FRM Rate: This means that the borrower would profit from refinancing immediately. He would also profit after the next ARM rate adjustment unless the index fell by enough to bring the new ARM rate below the FRM rate. Case for refinance: Very strong.

Both the ARM Rate and the FIR Are Below the FRM Rate: This means that refinancing is a loser now, and will to be a loser after the next ARM rate adjustment unless the index rose enough to bring the new ARM rate above the FRM rate. Case for refinance: Weak, except for the most risk averse borrowers.

The ARM Rate is Below While the FIR is Above the FRM Rate: This means that the borrower would lose money by refinancing the ARM now, but the situation will be reversed at the next ARM rate adjustment. Case for refinance: Strong, but unless the borrower is very risk averse, it makes sense to wait until shortly before the next rate adjustment.

This is the most common situation. Some borrowers get spooked into hasty action by fear that rates will be higher in the future, which could happen; but rates could also be lower. My advice is not to give up the clear benefit of holding the ARM until the rate adjusts unless the current FRM rate is about the maximum the borrower can afford. In that case, the reward from hanging onto the ARM until the rate adjusts is outweighed by the risk.

The ARM Rate is Above While the FIR is Below the FRM Rate: This means that the borrower would profit from refinancing the ARM now, but the situation will reverse itself after the next rate adjustment.

It is clear that if the borrower refinances in this case, it should be done immediately. What is not clear is whether the short-term savings from getting rid of the high-priced ARM now justifies giving up a lower ARM rate in the future. This is a situation that requires calculator 3e, Refinancing an ARM Into an FRM. And while the situation is uncommon today, it would quickly become common if rates begin another downward trend.

An ARM-Into-FRM Calculator

Here are some of the major factors the calculator uses:

Time Horizon: In general, the longer the borrower expects to remain in the house, the stronger the case for the refinance. More bad things can happen to the ARM over a longer period.

ARM Features: Refinance is a less attractive option for ARMs with particularly desirable features. These include a low current rate, a long period to the next rate adjustment, a low rate adjustment cap, a low maximum rate, and a small margin. Note: The margin is added to the rate index to determine the new rate on an adjustment date, subject to the adjustment cap and maximum rate.

FRM Features: The rate on the new FRM will be higher than the ARM rate, but much depends on how much higher it is. Further, account must be taken of refinance costs, including points, other lender fees and other settlement costs, all of which reduce the benefit of a refinance.

Prepayment Penalty: A prepayment penalty on the ARM acts just like an additional fee on the FRM, since you only pay it if you refinance.

Mortgage Insurance: If the borrower is paying for mortgage insurance on the ARM but the house has since appreciated, the FRM might not require the insurance. Even if it is required, the premiums on FRMs are lower. This would be a partial offset to the costs of the FRM.

Assumptions About Future Interest Rates: A critical factor affecting the results is the assumption you make about future interest rates. Calculator 3e allows you to assume many different future rate patterns, including "stable index" and "worst case". Another approach allows you to specify a rate increase each year, beginning in a specified year, and continuing for a specified number of years.

A Refinancing Decision Strategy Using the Calculator

One decision strategy is to try rising rate scenarios of increasing severity until you find the one in which the costs of the ARM and FRM in your case are about the same. This tells you how big a rise in rates is required to make refinance into an FRM profitable for you.

If I did this, for example, and found that any increase in rates greater than .5% per year for 3 years made the refinance profitable, I would refinance. If I found that it took a 2% rise each year for 5 years for the refinance to be profitable, I would stay with my ARM. If the results fell between these two, I would consult my astrologist.