Housing Finances

Should You Ditch Your Adjustable-Rate Mortgage?

Written by Zillow.com
Published Dec 24, 2012
2 min read
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In the past several years, many homeowners looking for lower monthly mortgage payments took out adjustable-rate mortgages to purchase or refinance their homes.

As both mortgage rates and short-term interest rates remain low, many borrowers are now wondering whether moving into a fixed-rate loan makes financial sense for them.

Here are a few things to consider:

Factors at play

1. Short-term interest rates are low. Your rate is usually pegged to the 12-month Libor (London Interbank Offered Rate) index.

The value is currently at .84 percent, and your margin is most likely somewhere around 2 to 3 percent, call it 2.5 percent (index + margin equals your interest rate).

2. Fixed-rate mortgages, such as the 30-year fixed rate mortgage, make an alternative to a fixed-debt structure.

3. You’ll need at least 3 percent equity in your primary home to refinance.

4. Can paying down the principal balance justify the refi? The return on equity by means of payment reduction will far likely outweigh your money market returns.

If, for example, it takes $50,000 to free up $400 per month, you’ll receive a 10.42 percent return on your money versus the 0.5 percent return from the bank.

Adjustable-rate vs. fixed rate

In a typical mortgage rate pricing pattern, you will usually see a spread of around 1 percent in a rate comparing a 30-year fixed rate mortgage with an adjustable-rate mortgage such as a 5/1 ARM.

For example, some borrowers are currently being quoted rates of 3.24 percent for 30-year fixed mortgages and 2.4 percent for 5/1 ARMs.

So, with interest rates hovering near those historic lows, is now a good time to move from an adjustable-rate mortgage to a fixed-rate loan?

The answer depends on how long you plan to own your home and the amount of risk you’re willing to take when it comes to your monthly payments.

Switching to a fixed-rate loan would allow you to rest assured that your principal and interest payments would remain consistent throughout the life of the loan, whether you own the home for another three years or 30.

Sticking with an adjustable-rate mortgage, however, means that you’ll face annual adjustments to your interest rate and monthly payments.

For a 3/1 ARM, for example, the interest rate will be set rate for three years, then will reset every year for the remaining 27 years of the original 30-year term.

If you’re convinced that you’re living in the home of your dreams, then the stability and reliability that a fixed-rate loan offers may be more appealing to you than facing the annual payment uncertainty.

If, however, you’re likely to sell soon or tend to relocate often for work, then the lower interest rates and payments of an adjustable-rate mortgage might make more financial sense for you and your shorter-term ownership needs.

“Should You Ditch Your Adjustable-Rate Mortgage?” was provided by Zillow.com.