Do This If You Have 3+ Years Left on Your ARM

Escaping an adjustable-rate mortgage is one of the strongest reasons for a refinance. Life is unpredictable enough already. Who needs a question mark hanging over their payment amount every year? An ARM makes financial planning harder. Long-term goals like retirement savings and college tuition can be upturned when a person's mortgage rate adjusts upward.

On the other hand, an ARM might have been the only way for some people to become homeowners. Qualifying for an ARM allowed them to buy a house and start building equity at a point in their life when their credit wasn't very good and their job history was shaky.

Refinancing is actually one of three decent reasons for homebuyers to choose an ARM over a fixed-rate mortgage, according to financial services company Charles Schwab. People who expect to refinance in a few years could get a lower interest rate with an ARM. Then before the ARM adjusts higher, they refinance. The other reasons that people might choose an adjustable rate over a fixed rate is they plan to sell the house soon (flip it) or pay it off fairly quickly, before the ARM can rise.

Heads-up
Sometimes paying off a mortgage early incurs a prepayment penalty.

So adjustable-rate mortgages definitely have their place, but built into them is a ticking clock. Interest rates have been low for quite a while. Nobody has a crystal ball, but analysts have been saying, "Don't get used to it" for some time now. Tomorrow's higher rates are why switching your adjustable-rate mortgage to a fixed-rate mortgage could be so important today.

How Long You Plan to Live There Matters

On her popular CNBC show, finance expert Suze Orman tackled the subject of ARMs versus fixed-rate mortgages: "If you have an adjustable-rate mortgage, should you be refinancing to get a fixed-rate mortgage? What should you be doing?. The answer to that question will depend on how long you're going to be keeping the house you already have."

Orman urged homeowners in adjustable-rate mortgages to evaluate their refi needs in terms of how long they plan to own the house. This is because a refinance carries closing costs just like any other home loan, and it will take time to recoup those costs in the form of lower payments.

The money you save each month offsets what you had to spend to get the loan started, and eventually you break even. This is called the breakeven point of a refinance. Only after the breakeven point do you actually start saving money.

Breakeven formula

Breakeven Point = Closing Costs ÷ Monthly Savings

If you plan on selling the house in a year or so, Orman said, "just stay where you are. However, if you're going to be keeping that house for five years, 10 years, maybe even 15 years, 20 years, or longer, and the interest rate on your adjustable-rate mortgage is above right now what a 30-year fixed-rate mortgage happens to be, you might want to look into transferring that."

Related
Everything you need to know about an ARM

Homeowners who plan to sell in a year or two won't have time to reach the breakeven point, plain and simple. Granted, those people probably aren't in the market for a refinance anyway. A good breakeven point is 30 months or less, so if you have three or more years left on an ARM, consider refinancing to a fixed rate.

"The key here is you're going to be staying in your house long enough to recoup the closing costs," said Orman.

Conclusion

Since interest rates have been low for some time, most people predict them going in only one direction: up. Having an adjustable-rate mortgage that is set to change in three or more years probably means your payment will rise. So if you plan to live in the house for more than four or five years, now would be a good time to consider swapping the ARM for a fixed rate. You will be living in the home long enough, making the lower payment, to break even with the closing costs. And your payment will never increase!