What to know about refinancing an ARM loan
Quick insights
- Refinancing an adjustable-rate mortgage (ARM) into a fixed-rate mortgage can provide consistent monthly payments, reducing financial uncertainty as interest rates change.
- Refinancing is often beneficial when market rates are favorable; however, it’s important to consider closing costs and prepayment penalties.
- To refinance an ARM, homeowners must meet lender requirements for credit score, home equity and debt-to-income (DTI) ratio, among other factors.
Adjustable-rate mortgages (ARMs) are, for many, the ticket to first-time homeownership. However, what happens when the initial interest rate changes or if your financial circumstances change?
The good news is there’s a solution available to some homeowners in this case: refinancing. But can you refinance an ARM loan, and what do you have to do to ease that process?
What is an adjustable-rate mortgage?
An adjustable-rate mortgage is a loan where the interest rate changes over time. This is unlike a fixed-rate mortgage, where monthly payments remain consistent through the life of the loan. An ARM typically starts with a lower interest rate and offers affordable payments through the initial period. Once this fixed period ends, however, the rate adjusts periodically based on the terms of the loan and existing market conditions.
One fear many homeowners have is that their ARM interest rates will increase exponentially. While they can rise significantly depending on the market, the sky isn’t the limit. In fact, ARMs include “rate caps” that set limits on how much your interest rate—and therefore, payments—can change.
Can you refinance an ARM loan?
Not only is it possible to refinance an ARM loan, but it can also be a smart choice for many homeowners looking to avoid rate hikes. Refinancing allows you to replace your ARM with a new loan, often a fixed-rate mortgage, to help you lock in more predictable payments.
In an unpredictable rate market, borrowers might opt to refinance their adjustable-rate mortgages before their rates reset. Refinancing now can offer long-term stability, especially if you plan to stay in the home for several years.
Refinancing an ARM loan to a fixed-rate loan
Many homeowners wonder whether you can refinance an ARM to a fixed loan. You can, and this can be a good idea when market rates are favorable or when your initial fixed period is ending.
By refinancing your ARM into a fixed-rate mortgage, you stabilize your interest rate and monthly payment, providing more peace of mind for the remainder of the loan term.
Before taking this leap, consider if the long-term savings outweigh the initial expenses; refinancing comes with closing costs and fees similar to the original loan process.
Why would you want to refinance a mortgage ARM?
There are a few reasons why homeowners may find ARM refinancing attractive.
More consistent monthly payment
One of the main reasons homeowners refinance their ARM is to switch to a fixed-rate mortgage. This can help secure predictable monthly payments, giving some financial consistency even as rates change.
Different repayment period
Looking to pay off your mortgage sooner? Or maybe you want to lower your payments by spreading them over a longer term? Refinancing lets you reset the clock, potentially aligning your loan term with your financial goals.
Lower interest rates
Timing is important when it comes to refinancing. If current rates are lower than what your ARM is set to adjust to, refinancing could save you in monthly payments and overall interest.
To remove a name from the mortgage
If you’ve gone through certain situations, such as divorce or separation, refinancing can remove someone’s name from the mortgage. This would allow a new borrower(s) to take full financial responsibility for the loan moving forward.
Higher credit score
Have you improved your credit score since you got your ARM loan? If so, you may now qualify for better interest rates or more favorable loan terms, making refinancing an even more attractive option.
How to refinance an adjustable-rate mortgage
Refinancing an ARM loan means replacing your current mortgage with a new one. Homeowners typically refinance to switch from an ARM to a fixed-rate mortgage, especially as market conditions change, though that’s not always the case.
Regardless, here’s how the process generally works:
- Choose a lender: Take the time to shop around for lenders. Different lenders offer varying interest rates, terms and fees. Compare their refinancing options carefully before committing.
- Apply to refinance: Once you’ve chosen a lender, submit your application along with information about your finances, employment and property.
- Provide necessary documentation: Your lender will request documentation to verify your income, debts and assets. This usually includes pay stubs, W-2 forms, bank statements and details about your current loan.
- Choose the type of loan: During the refinancing process, you’ll decide if you want to stick with another ARM or refinance into a fixed-rate mortgage. Many borrowers choose to switch to a fixed-rate loan to lock in stability and avoid fluctuating interest rates.
- Get approved: Once your documentation is reviewed, your lender will determine whether you're approved for refinancing based on factors like credit score and DTI ratio.
- Close on the new mortgage: After approval, you’ll finalize your new mortgage at the closing table. This is where you’ll pay closing costs, although it’s important to note that some lenders offer a “no closing cost refinance” option by rolling the costs in your new loan. Just keep in mind that this might result in a slightly higher interest rate.
What are the requirements to refinance an ARM loan?
Contrary to what some people might assume, the ability to refinance isn’t automatically guaranteed. To increase your chances of approval, you’ll need to make sure you meet most, if not all, of the qualifications. For example, depending on the type of loan product you are using, you may need up to 20% in equity to qualify for a refinance.
Refinancing generally also requires an appraisal. This will help lenders determine its current approximate value. You’ll also need to meet the lender requirements for DTI ratio and credit score.
When refinancing might not be the right choice
While refinancing an adjustable-rate mortgage can have its perks, it’s not always the right move. Here are some situations in which it might be better to hold off.
Interest rates have increased
If current rates have risen since you signed your ARM loan, refinancing might not save you money. For example, switching to a fixed-rate loan when rates are climbing could lock you into higher monthly payments.
You’re not planning on living in the home long-term
Planning to move in the next few years? Refinancing may not be worth it if you won’t be in the home long enough to reap the financial benefits. Instead, it may make sense to stick with your ARM until you sell.
You plan on paying down the balance
If you’re able to aggressively pay down your ARM loan balance, refinancing might not be necessary. Paying off your loan quickly could save you money on accrued interest without the need for added closing costs.
Your credit score, DTI or home equity may not meet the lender’s requirements
Refinancing typically requires certain minimums for credit score, debt-to-income ratio and home equity. If you fall short in any of these areas, your lender might deny your application or offer unfavorable terms.
You can’t afford the closing costs or potential prepayment penalties
Refinancing comes with a price tag: closing costs, which cover fees like credit reports, appraisals and title services. Some ARMs may charge a penalty if you refinance or sell within the first 3-5 years, known as a prepayment penalty. This could be a fixed amount or a percentage of your loan balance and make refinancing less appealing.
Make sure you calculate how long it will take to recover these costs through savings in monthly payments or interest. If the break-even point feels too far off, refinancing might not be the best move.
Is there a penalty for refinancing an ARM loan?
This is a common concern among homeowners who are curious about refinancing, but the answer depends on the details of your original mortgage agreement.
Some ARM loans include prepayment penalties, which are fees incurred if you refinance or pay off your mortgage early, usually within the first few years. These penalties can be a percentage of the loan balance or a set number of months’ worth of interest.
To avoid any surprises, be sure to review your loan’s terms and consult with your lender to confirm whether any fees might apply. If your ARM loan is penalty-free, refinancing may provide you with a smoother path to a fixed-rate loan or a lower interest rate.
In summary
Refinancing an ARM loan can be a strategic financial move, especially if interest rates are rising or if you’re looking for consistent monthly payments through a fixed-rate mortgage. By understanding the process and eligibility requirements described above, you can set yourself up for refinancing success.
If you’re ready to refinance your mortgage, explore lenders and compare options today to find the loan that fits your goals.
After all, refinancing isn’t just about switching loans. It’s about planning your financial future.
