One of the most important decisions a homeowner will have to make when deciding to refinance their home is whether they want to refinance to a fixed rate mortgage, or to an adjustable rate mortgage (ARM) or a hybrid loan which is a fixed rate for three to ten years then converts to an adjustable rate after three to ten years. The names are pretty much self explanatory but basically a fixed rate mortgage is a mortgage where the interest rate remains constant and an ARM is a mortgage where the interest rate varies. The amount the interest rate varies is usually tied to an index such as the Libor, 12 month MTA or Treasury index. Additionally there is a clause defined in the promissory note of an ARM which prevents the interest rate from rising or dropping dramatically during a specific period of time. This safety clause provides protection for both the homeowner and the lender.
Advantages of a Fixed Option
The option to refinance to a fixed rate is ideal for homeowners who want to keep their payment stable. Homeowners who refinance into a fixed rate mortgage from a variable rate do not have to be concerned about how their payments may vary during the course of the loan term.
Disadvantages of a Fixed Option
Although the ability to lock in a favorable interest rate is an advantage it can also be a disadvantage. This is because homeowners who refinance to obtain an attractive fixed interest rate will not be able to take advantage of interest rates drops unless they refinance again in the future. If the homeowner chooses to refinance again, they will incur additional closing costs. On the other hand those additional closing costs are offset by appreciation in home value.
Advantages of an ARM Option
Refinancing to an ARM is favorable in situations where interest rates are expected to drop in the near future. A homeowner who can predict the future would be able to determine whether or not an ARM is the best refinancing option. However, since this is not always possible homeowners have to either rely on their instincts and hope for the best or select a more stable option such as the fixed rate mortgage.
Disadvantages of an ARM Option
The most obvious disadvantage to refinancing into an ARM is that the interest rate may rise significantly due to unforeseen circumstances. In these situations the homeowner may suddenly find themselves paying significantly more each month because their adjustable rate index has risen. Although it is a disadvantage, the clause in the promissory note prevents the interest rate from being raised or lowered by a maximum percentage over a certain period of time.
Consider Refinancing to a Hybrid Loan
Homeowners who are undecided and find certain aspects of fixed rate mortgages as well as certain aspects of ARMs to be attractive might consider the hybrid loan. A hybrid loans is one which combines both fixed interest rates and adjustable interest rates. This is normally done by offering a fixed interest rate for an introductory period, usually three to ten years, and then converting the mortgage to an ARM for the remaining loan term. In this option, lenders typically offer interest rates which are extremely attractive to encourage homeowners to choose this option. Now that you have the knowledge you can make a wise refinance decision.
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