Deciding Whether to Refinance an Adjustable-Rate Mortgage
Q We bought our condominium in August. At that time, interest rates on fixed-rate mortgages were hovering over 10 percent. In order to help us qualify for a mortgage, our lender persuaded us to get an adjustable-rate mortgage, which had an initial interest rate of 7.78 percent. This is adjusted yearly, using a formula of prime rate plus 2 percent, and has a 2 percent cap per year, with a total rate ceiling of 13 percent. Subsequent to closing on our condo, our annual income has increased while the interest rates on fixed-rate mortgages have fallen to around 8 1/2 percent. Consequently, we are considering refinancing our ARM. We know it is generally financially advantageous to refinance a fixed-rate mortgage if the interest rate on the new mortgage is at least 2 percent less than the existing mortgage. Is there such a rule of thumb regarding refinancing of ARMs?</br></br>A Common sense-mixed with a little gambler's intuition-should be your best test of whether to refinance.</br></br>It really does not make a difference whether you have an adjustable-rate mortgage or a fixed-rate mortgage when you are considering refinancing. If you have a loan, such as an ARM, which can conceivably go up to 13 percent, you may want to consider locking in a good rate now as a hedge againt future inflation. After all, you don't need much vision to understand that an 8 1/2 percent loan, fixed for 30 years, is better than paying 13 percent on the same loan.</br></br>Keep in mind that when you refinance, in effect you have to start all over again. You have to have the title researched, obtain a new survey (other than for a condominium), pay points (with each point equal to 1 percent of the loan amount) and other closing costs, and there may even be some additional recording taxes imposed by the jurisdiction where your house is located. Thus, we have the usual rule of thumb that it makes sense to refinance when the rate drops about 2 percent-since you will have some up-front costs to pay when you obtain your refinancing proceeds.</br></br>Clearly, anyone who has a loan of 10 1/2 percent or higher should give serious thought to refinancing. Rates are now at the lowest level they have been in perhaps 10 years, and no one can guarantee that they will stay this low much longer. If, for example, you have a $100,000 loan at 11 percent, amortized over 30 years, your monthly payment (principal and interest only) is $952.33. If you can refinance this same $100,000 loan and obtain a new 30-year rate at 8.78 percent, the monthly payment is $795.65. This is a savings of $156 a month. However, to obtain this new loan, you will probably have to pay a minimum of three points ($3,000), and perhaps another $1,000 in closing costs. Thus, while you are going to ultimately save $156 per month, it will take you almost 26 months before you break even. To calculate this, take your $4,000 in up-front costs, and divide that by the $156 of monthly savings.