Reader question: “I have an ARM loan, and frankly I don’t know what I was thinking when I chose it. We are in this house for the long haul, so to speak, and will not be moving from our current residence anytime in the foreseeable future. I have heard that interest rates may rise over the next few years, so I want to switch out of my ARM and into a fixed mortgage. How do I convert my ARM to fixed? Is refinancing the only way to do that?”
You will probably need to refinance your current mortgage, if you want to convert it from an ARM to a fixed-rate loan. I don’t think there’s any other way to do it, without refinancing (though I could be wrong on that). This is actually one of the most common reasons why people refinance their homes, to convert from an unpredictable ARM to a more stable and predictable fixed-rate loan. You’ll need a certain amount of equity and a decent credit score. But it can be done.
Common Strategy: Refinancing from ARM to Fixed
Statistics show that most home buyers who use adjustable-rate mortgages try to refinance the loan before the first adjustment comes along. For example, a person who uses a 5/1 ARM (with a fixed interest rate for the first five years of the term) will usually attempt to convert over to a fixed-rate product before the five-year mark.
Why? They do this to get a lower rate on the front end, while avoiding the long-term uncertainty of adjustable loans.
Most ARMs start off with a pretty low interest rate during the initial phase, lower than a fixed mortgage. This appeals to borrowers who are trying to keep their monthly payments as low as possible, particularly during the first few years. But after those first few years, the loan will start adjusting to a new interest rate on a periodic basis — usually every year, for the remainder of the term!
If you can use an adjustable-rate mortgage and refinance out of it later on, before the ARM loan resets, you’re in good shape. But the problem a lot of people are having right now is that they cannot refinance or sell their homes (for a variety of reasons), so they are basically stuck with their adjustable mortgages and the uncertainty of the adjustment period.
Don’t get me wrong. There are certain occasions when it does make sense to use an ARM instead of a fixed loan. One example would be when you’re living in a house for only a few years, after which you will sell the home and move. In this kind of scenario, you could use an adjustable-rate product to save money during the initial phase, and then sell the home before you reach the adjustment phase. So this strategy could save you money while avoiding long-term risk at the same time.
But you clearly want to convert your adjustable-rate loan into a fixed-rate product. So let’s get back to that.
Switching to a More Stable Loan
When you refinance, you are basically replacing your current loan with a new one. The new loan can have a different interest rate, a different rate structure, and a different term (or length) from the old one. So you can use this strategy to convert from an ARM to a fixed mortgage. In fact, thousands of homeowners do this each and every year. It’s one of the most common reasons for refinancing, right behind monthly-payment reduction.
You might even be able to kill two birds with one stone, so to speak. Depending on the rate you are paying right now, you might be able to refinance to convert your ARM into a fixed rate, while securing a lower mortgage rate at the same time. So you could walk away with a more stable loan, as well as a smaller payment each month. Bonus!
Before you decide anything, check to see if your current loan has a prepayment penalty. These penalties aren’t used as much these days (2014) — they were much more common in the past. If you refinance before the term expires, and you do in fact have a prepayment penalty in effect, you might end up paying so much that you erase the benefits of refinancing. Your lender or loan servicer should be able to tell you if you have one and how it might affect you.
When you refinance to convert / switch your ARM to a fixed-rate loan, you will probably encounter some closing costs as well. Just like you did the first time around, when you closed on the original purchase mortgage. You want to make sure you’ll be in the home (and keep the new loan) long enough to “break even” between costs and savings, or better. This means the money you save each month begins to exceed the amount paid to originate and close the new loan.
Of course, if your primary goal is simply to convert from an ARM loan to a fixed rate, this may be less of a concern. But the ideal scenario is to land a fixed mortgage while also saving money over the long term, due to paying less interest.
My advice at this point would be to speak to a lender or broker. Tell them what you are trying to accomplish, that you want to switch from an ARM to a fixed-rate home loan. See if it’s possible to do that while also lowering your monthly payments. Ask them where the “break-even point” would be in such a scenario. Find out if you have a prepayment penalty. You need to see how it all works on paper, and how it’s going to affect (A) your monthly payments and (B) the amount of interest you pay over the long haul.