When the is raising interest rates, your adjustable rate mortgage probably needs to be refinanced. The reason is because adjustable rate mortgages (ARMs) are priced based off a short-term rate index plus a margin, such as the Fed Funds rate or LIBOR. When the Fed Funds or LIBOR rate starts rising, so will your ARM upon reset.
Below is a case study in the past when the Fed was raising the Fed Funds rate. I warned ARM holders to refinance before their fixed rate resets. Today, mortgage rates are at all-time lows.
Further, there are kinks in the mortgage market. Getting a 30-year fixed rate mortgage or a 15-year fixed rate mortgage is relatively better value now.
Your Adjustable Rate Mortgage Probably Needs To Be Refinanced
For those of you who’ve wisely taken out adjustable rate mortgages (ARMs) over the past 30+ years, pat yourself on the back. You’ve saved plenty of money by paying a much lower interest than if you took out a 30-year fixed mortgage.
Getting a 30-year fixed mortgage has not been a financially optimal choice because most people sell after 7 years and the 10-year bond yield has been going down for the past 30+ years.
Even with the Fed finally raising the Fed Funds rate in December 2015, mortgage rates for NEW mortgages have declined by about 0.5% because the Fed doesn’t directly control mortgage or consumer lending interest rates. The market does. And right now, investors are piling into Treasuries due to fears of a global recession.
For anybody with an ARM mortgage, you need to read this post and refinance before your interest rate adjusts. Before December 2015, the Fed hadn’t raised rates since 2004 (see pic). As a result, most ARM holders blissfully saw their interest rates adjust flat to lower once the fixed period was over. Not any more!
Refinance Your Adjustable Rate Mortgage Today
I watch interest rates every day because the 10-year bond is in my portfolio. The stock market volatility of 2016 has seen Treasury bond prices surge as investors seek safety and liquidity. The 10-year yield collapsed to near all-time lows in 1H2016, but is marching higher as we enter 2017.
Japanese Government Bond yields now have negative real interest rates (same with Australia and Sweden), which means deflation might be back. From an economist’s point of view, nothing is more evil than seeing prices go down and having everyone believe prices will continue to go down. Consumption and investment grinds to a halt, and the economy gets stuck in a death spiral.
In 2021, the 10-year bond yield is under 1% and mortgages are at all-time lows.
Adjustable rate mortgages and 30-year fixed mortgages closely track the 10-year government bond yield. Back in January 2015, I was able to successfully lock in a 2.25% 5/1 ARM jumbo loan with Chase. Unfortunately, they rejected me two months later due to the inability to recognize my freelance income.
So far, after checking online with Credible, and checking offline with Citibank and Chase, the best 5/1 ARM jumbo loan I can get is 2.375% and zero points. That’s still pretty damn good, since my current 5/1 ARM is at 2.625% and expires in mid 2017. That said, it’s still not the same as the 2.25% I got in January 2015 even though the 10-year yield is at the same level.
Why Are Mortgage Rates Not Going Down Further?
The likely reason? Lower margins. It seems banks are no longer accepting as small a profit margin as they were back in 2015 because banks are today more cautious about our future economic well-being. Makes sense. Over the past couple years, bank stocks have gotten hammered. Further, I think most of us are far less bullish than we were a year ago.
When I asked my banker for details about my current 2.625% 5/1 ARM loan, she responded with the following information:
First Adjustment: 6/1/2017
Index: LIBOR (index as of this week: 1.14%)
When I asked her to confirm whether this meant my mortgage interest rate would be equal to Margin + Index = 3.39% if the first adjustment was today, she said YES. I spoke to the loan officer for 45 minutes to clarify all information to help provide the best information possible for this post.
Going from 2.625% to 3.39% is a whopping 29% increase! This means a $1,000,000 mortgage monthly payment would rise from $4,017 to $4,429 according to Credible’s mortgage calculator.
On the flip side, if I refinance down to 2.375%, payment would go down to $3,887 a month from $4,017. Saving $130 a month is nice, but the real benefit is saving myself from having to pay 3.39% and $542 a month extra after 6/1/2017!
Understand Your Mortgage Index
For those who don’t know, LIBOR is the average interbank interest rate at which a selection of banks on the London money market exchange are prepared to lend to one another. LIBOR comes in 7 maturities (from overnight to 12 months) and in five different currencies.
The LIBOR interest rate is used as a base rate by banks and other financial institutions. Rises and falls in the LIBOR interest rates can therefore impact interest rates for savings accounts, mortgages and loans.
However, notice how your money market savings account still hasn’t really risen as much. That’s because banks want to keep their costs low and realize they don’t need to entice new deposits because everybody is fleeing risky assets.
It is common to assume that so long as the 10-year yield would remain low, any adjustment in an ARM would simply adjust at the same rate or lower. After all, everything is interrelated in finance. The reality is, the interest rate adjustment all depends on what your ARM is indexed to. Most ARMs are indexed to LIBOR.
LIBOR Tracks The Fed Funds Rate
LIBOR moves very closely with the Fed Funds rate because both rates are SHORT TERM rates. See how LIBOR jumped by roughly 1% since July 2015 after the Fed raised the Fed Funds rate by only 0.25% in December 2015. That is a crazy jump!
The logical assumption is that LIBOR will now probably decline as the Fed isn’t raising rates as aggressively after such a volatile year and uncertainty with the election. At the beginning of 2016, the market believed the Fed would raise rates by 4 times. Now, a second rate hike is unlikely. LIBOR should stop rising so much, but it hasn’t.
If your ARM so happens to adjust during this LIBOR spike, then you’re unlucky because adjustments often lock for the next 12 month period.
To Do List For Those With ARMs
1) Find out what your mortgage interest rate’s margin and index. The most likely answer is that your ARM is indexed to the 12 Month LIBOR rate. If your ARM were to adjust today, the new rate will equal the margin + index.
2) Once the mortgage interest rate adjusts, ask how often will the interest rate, and therefore your payment adjust. Some ARMs after their initial fixed period might adjust monthly according to the LIBOR rate. Most ARMs will adjust once a year. The worst is to have your ARM adjust during a temporary spike up in LIBOR as we are seeing now and lock the higher rate for 12 months.
3) Ask what is the mortgage interest rate maximum lifetime cap is. Given your mortgage’s margin is fixed, the lifetime cap is really a protection on the index going too high. For example, my ARM’s lifetime cap is 5%.
4) Find out the current refinance rates for a 3/1 ARM, 5/1 ARM, 7/1 ARM, 10/1 ARM, 15-year fixed, and 30-year fixed and what your corresponding payments will be. I’m still not a fan of 30-year fixed mortgages. The interest rate is usually 1-1.5% higher than a 5/1 ARM. I hope everyone realizes by now that interest rates will stay low for a long time.
5) If you do refinance, clarify with the loan officer whether you are resetting the amortization schedule (start back to year 0 out of a 30 year amortization period) or keeping it the way it is (e.g. paid mortgage for 5 years, and will have 25 years left until the entire mortgage is paid in the new loan). It’s generally a good idea to keep your amortization schedule.
6) Take the cost of the refinance and divide it by your monthly interest savings. At the minimum, the break even period has to be less than the duration you plan to hold the property. The sooner the break even period the better. As a general rule, my recommendation is for 18 months or less and/or an interest rate differential of at least 0.375%.
Save Money During A Correction
Refinancing your mortgage is the one beautiful thing everybody should do in an economic downturn. You certainly want to do this before you potentially lose your job! Once you lose your W2 income, you are dead to banks. I absolutely will be trying to refinance again now that the 10-year yield is back down. My financials are stronger due to two years worth of consulting income and less debt.
I strongly believe most ARM holders DO NOT realize that once their ARM adjusts, the interest rate will be much higher than their existing rate due to a ramp in LIBOR. Do not be under the assumption that because the 10-year bond yield is collapsing, your ARM mortgage interest rate will cooperate.
To get the best mortgage rate, you must make banks compete against each other with written offers. The easiest way to get a whole bunch of offers is to apply for a no-commitment quote online. Either go with the best quote or use the information to get your existing bank to match or beat. This is exactly what I’m doing, and exactly what my Citi loan officer has requested from me. Banks do not want to lose your business.
Shop around for the latest mortgage rate. Check the latest mortgage rates online. You’ll get real quotes from pre-vetted, qualified lenders in under three minutes. The more free mortgage rate quotes you can get, the better. This way, you feel confident knowing you’re getting the lowest rate for your situation. Further, you can make lenders compete for your business.
Explore real estate crowdsourcing opportunities. Real estate will be strong due to consistently low mortgage rates. Take a look at Fundrise, one of the largest real estate crowdsourcing companies today. I’ve personally invested $810,000 in real estate crowdfunding. My goal is to diversify across America and earn income 100% passively. Fundrise is free to sign up and explore.
Although I don’t like the process of refinancing, I love the benefits! Too many people just make their mortgage payments like robots without thinking about how their rate is compared to current market conditions. So many folks could save thousands of dollars if they took the time and effort to refinance
Thanks a lot for your post. I just read it in May 2018.
My situation: I have a jumbo loan 7/1 ARM with a rate of 3.125%, and a margin of 2.5% over the LIBOR. The lifetime cap is 8.125%.
As the finance rate is moving up quickly now, I am a little bit worried that when the 7/1 ARM reset, my monthly payment would increase significantly.
What should I do, wait for a lower rate, refinance now, or sell the property around the ARM reset?
Financial Samurai says
It depends on how much liquidity you have and how many years left on your ARM. Rates have gone up about 0.5%, but I think they will stay at this level for years to come. I wouldn’t be alarmed.
Have you checked the latest rates? I like LendingTree to get competing bids.
Ok, trying to figure this all out. Wife and I are in early 40s. We currently have 9.5 years left on a 2.75/10 yr FRM down from 3.375 on a 15 year FRM. Currently $1950 of the $2580 (P&I) payment is going to principal. The refi was at no cost because we are with Fremont Bank. Love them! Owe 254K and house appraised for 518K. Wife and I have W2 income of 205-210K. 280K in 401K/503b and we will both have pensions through CalStrs in about 18 years. We work 185 days a year. 2K in principal, 2K towards pensions and 1800 goes to 403b per month. So I guess we are technically saving about 5,800/month. That said, lifestyle is just as important at this stage as building wealth. We also pay the IRS about 7K at tax time with both of us claiming 0. No debt but no cash reserve either. That said, was not prepared to find a dream home scenario in Cali on a hilltop (full acre) over looking a body of water. New construction and will run about 950K. The builder doesn’t sell on contingency. Need a 5% deposit to move forward which we would need to be creative to come up with without selling existing home. Would love to keep existing in home a perfect world, but a full 950K loan seems rediculous with our income. At the very least, we would like to make the dream home work after selling our existing home. What’s the play here?
PS Besides the house on the hill, we would also like to either ultimately live in San Diego or figure out how to have a vacation home there.
Sam, I may be missing something basic, but how frequently should one refinance an ARM? My understanding is the overall term is always 30 years. Your experience in the past decade seems to imply that it’s optimal to get a 5/1 and then refinance after 5-6 years. But if you continue to repeat this process and if the rates continue to follow your prediction of staying low, you’ll also continue to reset the loan to another 30 years. At some point, does it make sense to just refinance to a 15 year conventional and prepare to ride it out? And does the process of refinancing eventually just feels too exhausting to be worth it?
Financial Samurai says
Correct. Your mortgage will get recast back to a 30 year amortization period after every refinance. Therefore, it’s important to perpetually pay down principal as you go if you ever want to pay the mortgage off. There’s one camp where they say you should never pay off your mortgage due to the interest rate subsidies. I agree if you are in the highest tax brackets.
But I recommend paying off your mortgage by the time you retire. Here’s a longer post on why I paid off my mortgage for one property.
It most ARM cases over the past 15-20 years, ARMs would reset flat or maybe lower. But ARMs are tied to LIBOR, which is tied to the Fed Funds rate which finally got raised in Dec 2015. I don’t think the Fed will raise much at all for another 1-2 years. Too much uncertainty.
See this post: How Much Can An Adjustable Rate Mortgage Go Up Once The Fixed Rate Period Is OVer for further details.