One of the most important decisions a homeowner must make when deciding to refinance their home is whether they want to refinance with a fixed mortgage, an adjustable rate mortgage (ARM) or a hybrid loan that combines the two options. The names are almost self-explanatory, but basically a fixed-rate mortgage is a mortgage where the interest rate stays the same, while an ARM is a mortgage where the interest rate changes. The amount of interest rate change is usually tied to an index, such as the prime index. In addition, there are usually clauses that prevent the interest rate from rising or falling sharply over a specific period of time. This safety clause provides protection for both the homeowner and the lender.
Advantages of Fixed Options
Fixed refinance options are ideal for homeowners with good credit who are able to lock in a favorable interest rate. For these homeowners, the rate they are able to retain makes it worthwhile for the homeowner to refinance at the new rate. The main advantage of this type of refinancing option is stability. Homeowners refinancing at a fixed mortgage rate do not have to worry about how their payments will change over the life of the loan.
Disadvantages of the Fixed Option
While the ability to lock in a favorable interest rate is an advantage, it can also be considered a disadvantage. This is because homeowners who refinance to get a favorable rate will not be able to take advantage of subsequent rate decreases unless they refinance again in the future. This will result in the homeowner incurring additional closing costs when refinancing.
Advantages of the ARM Option
The ARM refinance option is advantageous in situations where interest rates are expected to decline in the near future. Homeowners who are good at predicting economic and interest rate trends may consider refinancing with an ARM if they expect interest rates to decline over the life of the loan. However, interest rates are related to many different factors and can rise unexpectedly at any time, despite the predictions made by industry experts.
A homeowner who can predict the future will be able to determine if an ARM is the best refinancing option. However, since this is not possible, a homeowner must rely on their intuition and hope for the best or choose a less risky option, such as a fixed rate.
Disadvantages of the ARM Option
The most obvious disadvantage of the ARM refinancing option is that interest rates can unexpectedly rise significantly. In this case, the homeowner may suddenly find themselves paying significantly more each month to compensate for the higher interest rate. While this is a disadvantage, there are some protective factors for both the homeowner and the lender. This usually comes in the form of a clause in the terms of the contract that prevents the interest rate from increasing or decreasing by a certain percentage over a specific period of time.
Consider a hybrid refinancing option
Homeowners who are hesitant and find certain aspects of a fixed-rate mortgage, as well as certain aspects of an ARM, attractive may want to consider a hybrid refinance option. A hybrid loan is a loan that combines a fixed rate with an adjustable rate. This is typically accomplished by offering a fixed rate during the introductory period and then converting the mortgage to an ARM. In this option, the lender usually offers an extremely attractive introductory rate to encourage homeowners to choose this option. A hybrid loan may also work in the opposite way, offering an ARM for a certain period of time and then converting the mortgage to a fixed-rate mortgage. This version can be quite risky, as the homeowner may find that the introductory period ends with an interest rate that is unfavorable to the homeowner.