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| The Basics | Refinancing out of an adjustable-rate mortgage
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As interest rates rise, some homeowners are abandoning storm-tossed ARMs for fixed-rate loans. The unusual part: They're opting for higher rates.
By Bankrate.com
As interest rates rise, some homeowners are jumping ship -- abandoning storm-tossed adjustable-rate mortgages for stately fixed-rate home loans.
What makes this phenomenon unusual is that, by switching from adjustables to fixed-rate loans, these borrowers are opting for higher rates -- for now, at least. It's more common for people to refinance into lower rates.
These homeowners give three reasons for tacking against the wind. - First, some refinance after deciding to keep a house longer than they originally intended.
- Second, some refinance because it's easier to make firm plans for the future if their mortgage rates can't fluctuate.
- Finally, some have simply changed their minds about mortgage rates, and think they're headed up for a long time.
Matt van Wyk is refinancing for all three reasons.
"To me, it was a question of, 'Do I want to sleep at night?'" says van Wyk, 33, of Deephaven, Minn. With his highly caffeinated mortgage, an easy sleep is hard to come by. He has a one-month LIBOR -- an adjustable-rate mortgage, or ARM, that can move up and down rapidly. He got his mortgage in December, and in the four months since, his rate has gone from 3.75% to 4.375 %, with no end in sight.
That's the way of the volatile LIBOR, which has risen about 1.8 percentage points in the last year. When van Wyk bought his house, the one-month LIBOR gave him the lowest rate he could get. "A LIBOR was perhaps a solution to buying a little more house than we could have afforded with a single income," van Wyk says. But the LIBOR's rapid rise has been scary. Van Wyk figures he will rest easier after he closes on a 30-year fixed-rate mortgage at 6.125%.
From a Ferrari to a station wagon
Now, switching from a one-month LIBOR to a 30-year fixed is like trading in a Ferrari for a station wagon. It's like breaking up with a rock star to marry an actuary. And to make the change after just four months, incurring a prepayment penalty -- well, you wonder what was going through van Wyk's mind. Did he make a mistake?
Van Wyk says it wasn't an error, but a change of mind. "After four months, we kind of started thinking we're pretty much going to be here for the foreseeable future," van Wyk says. "When we moved here it hadn't quite sunk in that this would be the place."
The van Wyks' home is about twice the size of the one they owned before. It's in a suburb built around a lake west of Minneapolis, a five-minute drive from his parents. They have a 15-month-old child, with another due in September, and the house is big enough to accommodate a family of four. Why not settle there for a long time?
So the family decided it would simplify their planning if they could count on the mortgage payment staying the same month to month. So they chose a $304,000 fixed-rate loan. It will have an interest-only option, allowing them to slide by during lean times. "I expect the next four or five years to be skimpy anyway," van Wyk says.
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He is staying with the same lender, who is charging two months' interest as a prepayment penalty for refinancing out of the LIBOR but waiving the closing costs on the 30-year fixed. Van Wyk believes that, over 30 years, the one-month LIBOR is a money-saver. But right now he is focusing on getting through his children's preschool years, making medium-term rate stability a higher priority than long-term savings.
If rates settle down, van Wyk wouldn't mind going back to a LIBOR-indexed mortgage. But he doesn't want to stick with one while rates are rising.
Experts say rates will rise
And rates are expected to keep going up. The Mortgage Bankers Association's forecast calls for mortgage rates to rise about three-quarters of a percentage point the rest of the year.
The MBA tracks mortgage applications, measuring the proportion of borrowers who are refinancing their loans (38.3% the first week of April) and the proportion who are opting for ARMs (35.2% the first week of April). But the MBA doesn't track what kind of loans refinancers are getting out of and getting into.
However, says Michael Fratantoni, MBA's senior director for single-family research, one can make educated guesses. Hybrid ARMs, in which the initial interest rate stays the same for three or more years, are increasingly popular. The inference is that a lot of people are refinancing into hybrid ARMs.
Bob Moulton, president of Americana Mortgage in New York, has a customer who just switched to a 30-year fixed from a 5/1 ARM, the most popular of the hybrid adjustables. A 5/1 ARM keeps its initial rate for five years, then adjusts annually.
Moulton's client got a 5/1 ARM at 5.125% a year ago "because they were planning on staying in the house for a five-year period." But now, he says, "they realize they're going to be there longer than they first anticipated."
Stability's a draw for fixed rates
"He and his wife were concerned about rates going up in the future and they want to have the stability of a 30-year fixed rate. So he refinanced and we put him in a 30-year conforming (mortgage) at 5.5% at no points." Moulton persuaded his client to lock in February, at the bottom of a rate dip. Rates went up soon after.
Moulton steadfastly declines to forecast rates, especially in the long term. His client looked at what would happen if rates continue to climb. His rate could go into the double digits in four years. He decided he would rather pay about $4,000 in closing costs to get a fixed-rate mortgage and eliminate that possibility. The monthly payments are roughly $100 higher with the fixed-rate loan -- about $5,000 over the next four years.
With the closing costs and higher monthly payments, Moulton's client is paying about $9,000 over the next four years to insure himself against the unsure possibility that the rate on his former 5/1 ARM will skyrocket in 2009. He is betting, then, that two things will happen: Adjustable rates will rise, and he will remain in his house for years. "If you're moving soon, I wouldn't do it," Moulton says.
How long will you own it?
Length of ownership seems to be the most-common deciding factor when people switch from ARMs to higher-rate fixed-rate loans. That was the case for Pat and Karen Morrison of Weston, Fla., whose situation is similar to that of the van Wyks. The Morrisons married 18 months ago, and their first child is due in June. Last June they moved to a bigger, one-story house. They kept their two-story townhouse and rent it out.
They took out a one-month LIBOR on 80% of the house's price. The low monthly payments on the house allowed them to keep the townhouse. The rent they collect is about $200 less than it costs to keep and maintain the townhouse, but they estimate that the townhouse's value is rising by about $3,000 a month. This is, after all, South Florida, where real-estate values are skyrocketing.
Something unexpected happened after they moved into their house.
They fell in love with it. "Basically, we think we're set," Pat Morrison says. "We were thinking about it short term, but now we're thinking of living here long term." And by long term, he means decades. "Now that we've lived here, we're thinking of retiring here."
Eventually, they might sell the townhouse and use the proceeds to pay off the home-equity line of credit they took out in lieu of a 20% down payment on the house. Or they might keep the townhouse, especially if they can raise the rent enough to generate positive cash flow.
They figure that if they're going to keep the house into retirement, they might as well fix the mortgage rate. They locked recently with their current lender, Homebanc, at 6.125%. The closing costs will run about $4,000.
The way Morrison looks at it, he would have paid a higher rate -- about 6.25% -- if he had gotten a 30-year fixed last June. Now he's grabbing a lower rate than he would have gotten last June, and in the meantime he saved enough money with the one-month LIBOR to offset the closing costs on the refinance.
"It wasn't a bad gamble, I guess," Morrison says. "At least it paid for itself."
By Holden Lewis, Bankrate.com
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