When interest rates are falling the case for refinancing is clear and obvious. If you can save money each month without big cash costs to refinance then getting new a mortgage is a winner.
But what about when rates are rising? In this situation there may not be any monthly savings. In fact, in some cases monthly costs may actually increase. Does refinancing in such a rate environment — the rate environment we’re seeing now — ever make sense?
Oddly enough, many borrowers — especially those with “nontraditional” loans issued during the past few years — would be smart to refinance, even in a period of rising rates.
While it may be true that interest levels are not as attractive as they were when historic lows were reached in 2003, it’s equally true that refinancing now may be a far better choice than waiting and perhaps facing even-higher rates in the future.
What circumstances am I talking about?
Let’s look at a borrower who knows with absolute certainty that future costs are going to rise — and rise steeply.
Example: You have a 30-year mortgage. Payments during the first five years are interest-only and fixed at 5.5 percent. The loan balance is $300,000 and the initial monthly payment for principal and interest is $1,703.37.
In year six, the loan becomes a 1-year ARM, there is still $300,000 left to repay but now only 25 years remain for the loan term. Also in year six interest rates are higher — let’s say the new rate is 6.5 percent. The new monthly payment for principal and interest in year six: $2,025.62.
Why did the monthly cost increase so much?
First, the original loan balance was not paid down during the first five years of the loan term. The result is that the original loan amount must now be repaid in 25 years rather than 30 years. Even if rates stayed the same, a shorter repayment period guarantees higher monthly costs.
Second, interest rates rose. In our example rates went from 5.5 to 6.5 percent, but they could rise more. For instance, if rates reached 8 percent in year six — a rate that has hardly been uncommon in the past 20 years — the monthly cost for principal and interest would be $2,315.45. At 9 percent the monthly cost would reach $2,517.59.
Given the potential for vastly-higher payments — and given the potential for increases in other costs such as utilities and property taxes — it can make great sense for borrowers with interest-only loans, “option” ARMs, and ARMs generally to convert to fixed-rate financing in the face of rising rates.
For instance: Imagine that rates are now 6.5 percent. Our borrower with the $300,000 loan balance gets a fixed-rate, 6.5 percent mortgage. He pays $1,896.20 per month for principal and interest over 30 years. Yes, that’s more than the current monthly payment of $1,703.37 — but more importantly the new monthly payment will not increase, a considerable benefit given the possibility of bankrupting future costs.
One ARM for Another?
The examples above argue that it makes sense to replace ARMs and non-traditional loans with fixed-rate financing when rates are expected to rise in the long-term. But does it ever make sense to replace one ARM with another?
Actually, within limited standards, it does.
ARMs are attractive for two reasons: ARM start rates are routinely below fixed-rate interest levels and ARM qualification standards tend to be more liberal, which means borrowers can get bigger loans with ARMs than with fixed-rate financing.
In terms of refinancing in a rising-rate environment, there’s one reason to consider replacing one ARM with another: Many combo-ARMs and interest-only loans have start periods where rates and payments are locked in for the first three, five, or seven years. The savings may not be significant relative to a fixed-rate loan, but the qualification requirements are likely to be more generous. This means that borrowers who are unable to qualify for fixed-rate loans and will soon face substantially-higher monthly costs may find financial shelter with another ARM or interest-only loan.
In effect, a substitute combo-ARM or interest-only loan can give you a few years of rate and payment stability — hopefully a period of time in which it will be possible to refinance to a lower-cost fixed-rate product or to sell the property on an attractive basis.