Adjustable-rate mortgages (ARMs) are risky, but they certainly have their uses. If the interest rate on ARMs is low and you're planning to sell after a few years, it can be a definite money-saver compared to a fixed-rate mortgage (FRM).

How Does Refinancing Work?

Refinancing is simply taking out a new mortgage to pay off the old one. To be eligible for refinancing, you will usually need to have a good credit rating, a steady income, and a certain amount of equity in your home. Bear in mind that taking out a new mortgage will mean another round of closing costs, and you may also have to pay a prepayment penalty on the original loan (check your mortgage documents to find out if you have a prepayment penalty and how much it is). Refinancing can cost between three and six percent of your current outstanding principal.

Reasons for Refinancing

There are three common reasons for refinancing out of an ARM into a fixed-rate mortgage. Believe it or not, it's quite common for people who are refinancing from an ARM to a fixed-rate mortgage to end up with a higher interest rate. For these people, however, it's a matter of thinking ahead and realizing that the benefits of the ARM are highly dependant on both the market and their individual situation.

  • Some people who opt for ARMs don't intend to stay in the house for more than a few years, and they're banking on the interest rate staying low for that time. However, sometimes the unexpected happens - they may fall in love with the house, and decide to stay there long-term. In that case, switching to a fixed-rate mortgage is a safer option.
  • It's easier to make long-term plans on a fixed-rate mortgage - when your mortgage rate is fluctuating and you're paying variable amounts of money from month to month, it's more difficult to control your cash flow.
  • Some people simply change their minds about what they think the market will do in the future - it may look good when they take out the loan, but the market can change direction quickly and if interest rates look set to increase for a long time, refinancing to a fixed-rate mortgage is a sensible option.

Should You Refinance?

If you're thinking about refinancing out of an ARM and into a FRM, there are four pieces of information you need.

  • The current interest rate on your ARM
  • How long until your next ARM rate adjustment
  • The current fully-indexed rate on your ARM
  • The rate and terms of FRMs on the market

The fully-indexed rate is the best predictor of how your ARM rate will change at the next adjustment. This rate is made up of the interest rate index that your ARM uses, plus the margin (both of these figures are shown on your note). You can find out the current value of the index online from a few different places, including Add the current index value to the margin to find out what your fully-indexed rate is. At your next adjustment date, your ARM rate will be reset to that figure (assuming the index doesn't change). If you find that both your ARM rate and your FIR rate are higher than current FRM rates, then you've got a very strong case for refinancing.