What to Do When Your ARM Adjusts

Facing a rate boost? You're better off converting to a fixed-rate loan.

Russell Wild is a poster boy for borrowers with adjustable-rate mortgages. When rates hit rock bottom in 2003, the financial planner and author traded in a 6.75%, 30-year fixed-rate mortgage on his four-bedroom colonial in Allentown, Pa., for a 5.12%, five-year ARM. He refinanced for $16,500 more than his old mortgage balance so that he could invest the extra cash, and he has dutifully been putting aside the $100-a-month savings on his mortgage payment. Assuming his portfolio continues to return 14% a year, as it has for the past three years, he'll have a kitty of $39,700 by the time his first adjustment kicks in.

That increase is capped at two percentage points a year (or 7.12%), so when his ARM's annual adjustments begin in December 2008, Wild won't pay much more than he did on his old fixed-rate mortgage. With a lifetime interest-rate cap of 10.12%, the worst-case scenario is a "nice fat tax write-off," he says. Will he refinance again? Maybe. "I've got nearly two years and plenty of options, one of which is paying off the mortgage altogether."

Although Wild isn't sweating the change, a lot of homeowners are. As home prices started to soar about five years ago, many buyers took advantage of low-rate ARMs just to get a foot in the door. At the same time, mortgage rates were flirting with historic lows, and lenders began offering more interest-only loans and option ARMs, which allow borrowers to make low minimum payments. "So many people did exactly the wrong thing at the wrong time," says Barry Glassman, a financial planner with Cassada & yCo., in McLean, Va. While many borrowers said they'd take the lower interest rate and put the money aside to offset higher payments later, most didn't.

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ARMs accounted for just 22% of mortgage originations last year. But in 2004 and 2005, ARMs accounted for about a third of home loans. The short-term indexes to which ARMs are tied have moved up sharply as the Federal Reserve has tightened credit. Of the ARMs due to reset this year, half will be refinanced, predicts the Mortgage Bankers Association. Glassman describes the coming wave of adjustments as an "ARM tsunami."

Adjustment blues. If you have an ARM, get out the life raft and start preparing. Jim McMillan, a loan officer with JP Mortgage/JPMorgan Chase, says that "What should I do with my ARM?" is the most common question he gets these days. To find the answer, start by pulling out the contract you got at settlement.

To calculate the rate on your loan when it adjusts, you need to know the index your ARM is based on (such as the one-year Treasury, 11th District COFI or LIBOR), the current rate on the index and the margin that's added to get your full rate. The only information your contract won't contain is the latest index rate, but you can get it for the most popular ARM indexes from HSH Associates, Financial Publishers. One bright spot: Most ARMs have an annual cap, often two percentage points.

When you have the skinny on your loan plus your latest balance, you can estimate your new payments (see the How much will my mortgage payments be? calculator. Say you took out a 5/1 ARM in late 2002 at 5.2% for $240,000. (A 5/1 ARM has a fixed rate for five years, then converts to a one-year ARM.) Your current principal-and-interest payment is $1,318. At the end of this year, assuming an annual cap of two percentage points, your rate would jump to 7.2%, upping your monthly payment to $1,588 on the remaining $220,647 loan balance.

Should you refinance? If you're planning to sell soon after your adjustment, refinancing may not be worth the cost and headaches. But if you're planning to stay in your home for a while, you'd be wise to lock in a fixed rate now.

Fixed rates are still fairly low -- recently 6.3% on 30-year mortgages -- and they should remain below 6.5% for the rest of the year. With rates for 5/1, 3/1 and one-year ARMs all hovering around 6%, the difference is minuscule. "If you can handle the kicker of a higher monthly payment, you can get a loan you'll never have to worry about again," says Keith Gumbinger, of HSH Associates.

If you refinanced to a 30-year fixed mortgage at 6.3% on the $220,647 loan in the example above, your monthly payment would be only $1,370, assuming you don't finance closing costs. (Expect to pay 2% to 4% of the loan amount in closing costs, or $4,000 to $8,000 on a $200,000 loan.) The calculators at Mortgage Professor can help you determine whether refinancing your ARM with a fixed-rate loan makes sense based on how long you plan to stay in your home.

Some borrowers who bought at the peak of the market with interest-only and option ARMs -- who have little, if any, equity in their homes -- could have trouble qualifying for the higher payments of a fixed-rate mortgage. That's especially true as lenders begin to tighten their standards. Another roadblock to refinancing is prepayment penalties. Last year, 84% of option ARMs carried a prepayment penalty that could force borrowers to come up with thousands of dollars if they decide to refinance within the first few years of their loan.