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Don’t Refinance ARMs in the Short Term

However, in the long run, we’re all dead – as economists like to say. But this is one of the first times I’ve read in an article where the expert is advising that someone in an adjustable rate mortgage (ARM) not refinance the loan (the circumstances make this the correct advice). The situation is this: 1/5 ARM at 4.5%, adjusting in 2009 with a maximum annual increase of 2.0% and a maximum interest rate of 9.9%. The advice by Dr. Don [3] (who has an impressive alphabet soup of degrees after his name) is that if that person is there for the “short term” (3-5 years) then leave it be, otherwise refinance at the roughly 7% interest rates for a 30-year fixed loan.

It’s a rough approximation, but if your loan balance is currently $100,000, refinancing a 4.5 percent loan three years before it becomes an 8.5 percent loan costs you $8,000 per year over the next three years. That’s $24,000 plus closing costs. Refinancing today at 7 percent will cost you an additional $7,500 over the next three years, versus the existing mortgage, plus closing costs. The interest expense is scalable, so a $200,000 loan balance would be twice as much plus closing costs.

So it’s a closing vosts vs. increase interest rate decision that puts you in the no-refinance camp if the adjustment doesn’t come for another three years, what (and the Bankrate article doesn’t address this) if the ARM readjusts this year?

Well, using Dinkytown.net’s ARM vs Fixed Mortgage calculator, the difference in the payment between a 30-year 7% fixed mortgage and an ARM (which was set for 4.5% for 12 months, then adjusted the max of 2% each year until 9.99%) on a $100,000 mortgage loan was:

Four year totals: 30-year fixed ARM Difference
Interest $27,409.07 $28,641.22 -$1,232.15
Principal $4,525.33 $4,441.94 $83.39
Total $31,934.40 $33,083.16 -$1148.76

So over 4 years, you pay only $1148.76 less on a fixed mortgage at 7% than you do on a 1/5 ARM adjusting in 12 months. I can guarantee you can’t refinance your mortgage for less than $1148.76. Let’s look at the numbers for the life of the loan (30 years):

Four year totals: 30-year fixed ARM Difference
Interest $139,510.98 $200,810.05 -$61,299.07
Principal $100,000.00 $100,000.00 $0.00
Total $239,510.98 $300,810.05 -$61,299.07

So, if you’re in it for the 30-year long haul… refinance, otherwise you can sit tight. Incidentally, at 3 years and 7 months is when your ARM payment will exceed your fixed 30-year mortgage payment.