When making this decision you need to have a firm idea of how long you plan to live in your current residence. This is the primary factor against which you measure the cost vs. benefits of a refinance.
Refinancing is not cheep. For a reference point let’s say that your refinance is going to cost you $2500.00.
Also, when making this decision you are relying on economic trends and the evaluation of our countries past interest rate patterns. Interest rates are at a low point and your adjustable rate may be very attractive. But, if history repeats itself, and it almost always does, interests rates are more likely than not to inch upwards over time. How high will it go before the pattern starts again? Economic Majors cannot answer that question after years of study, so I shall not assume to be able to do better than them. So, what are we left with?
Only a hypothetical situation can illustrate the value of making the switch. So, for the sake of ease, assume your balance is 100,000. And as a precaution we will use the lowest (and most risky) adjustable rate average. This is on a one-year adjustment schedule. The current average rate is 5.8% and I will set the loan at 30 years.
Currently the average fixed mortgage rate (and we will pick the worst scenario, which is a 30-year loan) is currently at 6.89% (up .02% since last week).
Now comes the guessing part. Let’s say that in the next three years we have an inflationary economy and interest rates climb. Consider that between 1977 and 1983 fixed rate mortgages rose to a record that topped 18%. I hope that we never see those types of numbers again, but if it happened once it could happen again. Ok, on with our hypothetical situation. So bearing in mind our past history, let’s guess that in 3 years the interest rates climb to 10%. Here is how the math works out.
Your payment now is: $586.75 (Of course remember, that over the lifetime of the loan you will pay out more in interest than in principle. So that 100,000 will suck up $211,321.10)
Now that the interest rates are at 10%, your adjustable rate mortgage is costing you: $877.57.
Your house payment has increased by about $290. Keep that number in mind, as we will need it later.
Ok, so you took the plunge and you changed to a fixed mortgage. Your interest rate of 6.89% will leave you with a house payment of: $657.93
Assume you plan to live in the house for 5 more years at least. In the five years that pass after the interest rate has risen to 10% you will have put out an additional $17,400. But you also have to consider the period of time when you were paying MORE for your fixed rate than your adjustable rate. That difference is about $75.00 a month. If it took 3 years for these rates to climb to that point and the jump was made all at once (no going to happen that way, but it makes the math easier) you will have paid out $2,700 more than you normally would have with your adjustable mortgage.
Now subtract the extra costs ($2,700 from the savings you gained by making the switch: $17,400) and you get a net return of $14,700. This is a HUGE return on your $2,500 refinance expense (which often can be rolled into the refinanced loan). In this case you will have made a fine decision.
Remember, this is all based on hypothetical numbers. I have always chosen fixed-rate mortgages that were 20 years or less and I will continue with that strategy should I decide to relocate again.
Bear in mind that the author of this article is a proponent of fixed-rate mortgages. And for my money I would make the switch…. now. But it’s a crapshoot, a guess, or a toss of the dice. As in all gambling or guessing games, you can win or you can loose, but I’m betting on past economic trends and the history of our ever climbing and plunging interest rates.
It is a lot of math, but the effort might save you thousands!