Consider an adjustable-rate mortgage when refinancing

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If you're looking for the lowest possible monthly mortgage payment, you might consider refinancing into an adjustable-rate mortgage.

ARMs are about as cheap as they've ever been.

And there is a growing gap between the interest rates on fixed-rate mortgages and ARMs that make the latter more appealing as well. The benefits can continue after the ARM resets if short-term interest rates remain low.

By choosing an ARM over a 30-year, fixed-rate mortgage, you could cut your interest rate by more than a percentage point. The average introductory rate for a five-year ARM was 3.4% in June, while 30-year, fixed-rate mortgages averaged 4.71%.

That could reduce the cost of your payments over the first five years to $443 a month for every $100,000 borrowed, which is about $75 less than with the average 30-year, fixed-rate loan.

Our adjustable-rate mortgage calculator can help you see how much you can save.

There’s an additional benefit to the ARM loan: You’ll be paying down the mortgage and building equity faster with the ARM than with the fixed-rate loan.

That's because more of your monthly mortgage payment with an ARM goes toward the principal.

We know many borrowers don't want to even consider an adjustable-rate mortgage because so many homeowners defaulted on the irresponsible, unaffordable ARMs lenders were peddling during the housing boom.

You just need to choose an adjustable-rate mortgage with reasonable terms so that you don't have to worry about making the payments, even if the rate increases several times.

That means a loan that resets no more than once a year and has the strictest limits on how quickly your interest rate can go up. Stay away from interest-only or option ARMs.

Look for an ARM with limits of 2/2/6, which means your rate can't go up more than two percentage points the first time it resets, or more than two percentage points any other time it resets, for a total of no more than six percentage points.

With an initial 3.4% loan, you would pay no more than $544 per $100,000 borrowed per month after the first reset and a maximum of $765 over the life of the loan.

Of course, you won't have to worry about reaching the rate cap if interest rates remain low or moderate. But you should be prepared to handle the higher payment in the event rates do rise or be prepared to refinance again.

As a result, refinancing into an ARM is only appropriate for certain homeowners.

You should only consider an ARM refi if you are confident you will have the mortgage only as long as the first reset. You might, for example, plan to sell your house, pay off the mortgage or refinance again prior to the reset.

Again, this is a mortgage for someone looking for the lowest possible monthly mortgage payment.

But if you’re risk averse, go with the fixed-rate mortgage.

Refinancing into a fixed-rate mortgage also makes more sense if you want to pay off your mortgage sooner by seeking a shorter loan term than the number of years you have remaining on your current loan.

John DeBiseglie, director of mortgage services at the Mutual Security Credit Union in Fairfield County, Conn., says many of his customers who refinance into an ARM are older people who are planning to retire in the next four or five years and looking to save money in the meantime before they sell their homes.

The credit union is currently offering an ARM that is fixed at 2.99% for the first two years, with an annual cap of one percentage point, meaning the rate can go no higher than 4.99% for the first four years. The loan has a lifetime cap of 8.875%.

This loan is also appealing to homeowners with large mortgages -- say more than $500,000 -- who are looking to reduce monthly housing expenses and invest the extra money. The monthly savings on a big mortgage can be particularly significant, DeBiseglie notes.

For example, the monthly payment on a $500,000 30-year, fixed-rate mortgage with a 5% APR would be about $2,685 a month.

But the payment on the 2.99% ARM would be only $2,105, a difference of $580 a month. That’s a savings of nearly $7,000 the first year and nearly $14,000 before the loan can adjust.

Credit unions often have more leeway in structuring mortgage loans to fit your individual needs. They typically have better rates and loan variations that can reduce your monthly mortgage payments, while also providing longer-term interest rate protection. To locate one near you, go to www.findacreditunion.com and check their mortgage rates.

To see if an ARM refi makes sense for you, check out our ARM vs. fixed-rate mortgage calculator, which can help you compare different types of loans.

Our extensive database of mortgage rates can help you to compare loans being offered by dozens of lenders in your area.

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