Is it a good time to refinance your adjustable-rate mortgage?

With mortgage rates falling to their lowest level this year, homeowners with adjustable-rate loans may be weighing whether now is the right time to refinance.

Let’s dive into when it makes sense to refinance, so you can decide whether sticking with an adjustable-rate mortgage or switching to a fixed-rate loan is a better option.

The differences between adjustable and fixed-rate mortgages narrow down to how the interest rates work for each loan.

A fixed-rate mortgage is a home loan with an interest rate that stays the same for the entire term. They typically have 15- and 30-year terms, but some lenders offer 10-, 20- and even 40- or 50-year loans.

Adjustable-rate mortgages, or ARMs, typically allow the homeowner to lock in a low fixed-interest rate for a predetermined period, such as three, five, seven or 10 years. Once the period ends, the rate becomes adjustable, changing based on current market trends and other factors. The loans, which typically have 30-year terms, can be structured to adjust every month, six months or annually.

For instance, a popular ARM structure includes the 7/6 ARM. Under this scenario, the initial interest rate is fixed for the first seven years, then the rate adjusts every six months.

ARMs can be more attractive when the rate is at least half a percent lower than the 30-year fixed, experts say. Another factor to consider is the outlook on interest rates: If you believe rates will continue to fall, opting for another ARM may be advantageous. If you expect rates to rise, locking in a fixed one could be the safer choice.

One way to look at your options is to figure out how long you plan on staying in the home. If this isn't your forever home, staying with an adjustable-rate mortgage can make sense. If you plan to stay in your home for longer, then a fixed-rate mortgage may offer stability. You'll want to estimate your break-even point — the time it takes for the savings from a lower fixed rate to outweigh the upfront costs.

Upfront costs are the fees and expenses paid at the time to finance or refinance your home and may include:

• Loan origination fees, which are charged by the lender
• Appraisal fees for assessing your home's value
• Application fees
• Government recording costs
• Credit report fees
• Title services
• Tax services fees
• Survey fees
• Attorney fees
• Underwriting fees
• Discount points if you decide to buy down your interest rate.

Let's say you're a borrower with the following situation:

• $400,000 adjustable-rate mortgage
• Interest rate: 6%
• Refi option: 5.5%

At 6%, your monthly principal and interest payment will be about $2,398. At 5.5%, your monthly payment will decline to about $2,271. That will save you about $127 per month or $1,524 per year. With closing costs of $5,000, you're break- even would be 39 months or 3.25 years. Refinancing will make sense if you plan to stay in your home longer than 3 years.

Your rate will be governed by several factors. They include:

Your ARM's rate is typically tied to the movement of a particular index. The most commonly used ones are:

• The Cost of Funds Index (COFI), which is an average of the interest rates that banks in a specific region pay to borrow money
• The London Interbank Offered Rate (LIBOR), a benchmark interest rate for short-term loans between major global banks
• The Constant Maturity Treasury (CMT), which is calculated by taking the average yield of different types of Treasury securities with different maturities
• Secured Overnight Financing Rate (SOFR), which is based on the interest rate banks charge one another to borrow money overnight.  

A margin is the number of percentage points the mortgage lender adds to the index to set your interest rate. These are disclosed at the time of the loan application and won’t change after closing. Margins can vary by lender. Ideally, you’ll want to shop around for a low margin.  

Let's say:

• Your ARM is tied to the SOFR index, which is hovering at 4.35%
• Your lender adds a margin of 3%

Your interest rate = Index (4.35%) + Margin (3%) = 7.35%. This is the rate your mortgage would adjust to after your fixed period ends, unless rate caps or other limits apply.

Rate caps are limits on how much the interest rate can change during each adjustment period or over the life of the loan. Some banks like Wells Fargo limit the initial interest rate cap to no more than 2% during the first adjustment period, according to Eric Gotsch, the lender's market manager. 

After that, a subsequent adjustment cap may apply, which means the rate can change by no more than 1% every six months. Finally, a lifetime cap ensures the rate will never increase more than 5% above the initial rate, Gotsch explained.

The experts differ on what makes sense.

Gotsch said refinancing a fixed-rate loan is traditionally recommended only if the new interest rate is at least 1% lower than the current one, but noted that this is a loose guideline and that decisions should be made case-by-case basis.

Bill Banfield, Rocket Cos.' chief business officer, recommends refinancing if rates drop by half a percentage point or more than what you have currently.

Gotsch emphasized that homeowners should consider three variables before deciding to refinance:

• The size of your mortgage balance
• Your estimated closing costs
• The improvement in your interest rate or monthly payment

Ideally, you’ll want to contact your existing servicer to find out the exact date when your rate ends and whether there are any costs associated with refinancing your ARM. According to Baret Kechian, a New Jersey branch manager for loanDepot, part of the discussion could include preparing your application. Some lenders may charge an application fee from $75 to $500 to process your refinancing request. Be sure to note that most ARMs have a 30-year amortization schedule, so refinancing would reset the term. This means that the borrower will start a new 30-year clock, even if they’ve already paid down several years on the original loan. However, some borrowers can choose to refinance into shorter terms, such as 15 or 20 years, if they want to pay off the loan faster and save on interest.

Let’s say you’re a homeowner with the following situation:

• Current mortgage balance: $500,000
• Current interest rate: 7%
• Refi option: 6%
• Estimated closing costs: $4,500

At 7%, your monthly principal and interest payment is about $3,327. At 6%, it drops to about $2,998. That's a saving of about $329 per month. This doesn't include private mortgage insurance or property taxes.

This calculation reflects how many months it will take to recoup your refinance costs.

Total loan costs divided by the monthly savings = number of months it will take to break even.

$4,500/ $329 = 13.7 months

If you plan to stay in the home longer than 14 months, refinancing could save you money. If you plan to move or refinance again sooner, you might not recoup the costs.

Refinance closing costs may vary by the size of your loan or where you live. But generally, you can expect costs to range from 2 to 6% of the outstanding loan amount.

For example, the cost to refinance a $500,000 loan generally ranges from $4,000 to $4,500. Many lenders, especially for existing clients, may waive certain fees or offer credits at closing to help keep costs low, Kechian explained.

Lenders could also require an assessment of your home’s current value to confirm that the property’s worth supports the loan amount. And your local government could charge you to record your new mortgage documents.

Refinancing expenses also vary depending on the loan type. For example, conventional loans are subject to loan-level price adjustments based on credit score, loan-to-value ratio and property type.

For example, with a conventional loan (a common type of mortgage not backed by the government), lenders adjust the price based on certain factors. These can include:

• Your credit score: Better scores usually mean lower costs.
• Loan-to-value ratio: This is how much you're borrowing compared to the home's value. A lower ratio is generally better.
• Property type: Whether it's a single-family home, condo, or investment property can affect the cost.

These are called "loan-level price adjustments," and they help lenders manage risk based on your financial profile and the property details.

Jumbo Loans

Conventional mortgages have limits set by the government, so if you need to borrow more than that, you'll need a jumbo loan. Borrowers with jumbo mortgages usually have fewer loan-level price adjustments compared to conventional packages.

That's because borrowers with jumbo loans often have stronger credit profiles, Banfield explained, which may make refinancing more attractive if the equity of the borrower has increased. This combination may offer greater flexibility and motivation to refinance, provided the borrower qualifies for favorable terms.

FHA and VA loans

For streamlined refinances through the Federal Housing Administration (FHA) or Veterans Administration (VA), borrowers typically need to reduce their interest rate by at least half a percentage point. These streamlined options involve minimal paperwork and fewer requirements, making the refinancing process simpler and more cost-effective.

In addition to considering the costs, it’s important to understand the impact on your creditworthiness. Soft credit checks during refinancing don’t affect your credit score. However, a hard credit check later in the process might have a minimal impact.

When you apply to refinance your mortgage, lenders will check your credit. There are two types of credit checks:

• Soft: This is a quick look at your credit history that doesn’t affect your credit score. It’s often used early in the refinancing process to give you an estimate or preapproval.
• Hard: This is a more detailed review that happens later, usually when you officially apply. It can cause a small, temporary drop in your credit score — typically just a few points.

So, while the initial steps won’t hurt your credit, the formal application might have a minor impact.

Buying down a point involves paying an upfront fee to reduce the interest rate on your mortgage. This strategy could be more cost-effective than a fixed-rate mortgage.

It could be beneficial if you plan to keep the mortgage long enough whether that's the fixed period of an ARM or significant portion of a fixed-rate loan's term. When you sell or refinance early, you may not recoup the upfront cost, Gotsch suggested.

Here's an example:

• 1 point = 1% of your loan amount
• Each point will lower your interest rate by 0.25% to 0.5% depending on the lender
• Loan amount: $500,000
• Term: 30 years
• Interest rate before: 7%
• Interest rate after buying 1 point: 6.75%
• Cost of 1 point: $5,000

At 7%, the monthly mortgage payment would be $3,326.51. At 6.75%, the monthly payment would be $3,242.99. You'd save $83.52 each month or $30,067 over the term of the loan, if you bought down your rate by 1 point.

Refinancing your mortgage within a specific timeframe (usually three, five or seven years) may trigger this form of penalty depending on your loan terms. However, most loans do not have prepayment penalties, according to Banfield.

More on this topic

• What falling mortgage rates could mean for home sellers. Pricing, inventory and market timing explained.
• Mortgage rate averages see sharpest weekly decline in nearly a year
• Fixed-rate vs. adjustable-rate mortgages
• Fed makes first interest rate cut in nine months. Two more anticipated before year's end.
• Your questions about the Federal Reserve answered
• Understanding the mortgage process from preapproval to closing
• How can sidelined homebuyers take advantage of lower mortgage rates?