Is it time to refinance into fixed-rate loan?

Last year, I wrote an article advising borrowers on how to determine whether refinancing an adjustable-rate mortgage (ARM) into a fixed-rate mortgage (FRM) was advantageous. On recently rereading that article, I winced with the realization that I had made the problem more complicated than it had to be. Since the question continues to confront many borrowers, this article attempts to make amends.

The problem with my previous article is that it implies that a borrower cannot conclusively determine whether refinancing will pay without using a calculator. That is not the case. While writing the article, I developed a calculator to address the problem, and I allowed myself to become so heavily invested in it that I couldn't see any way to operate without it.

To properly assess this refinance decision, the borrower needs four pieces of information: 1) The current rate on his/her ARM; 2) The period until the next ARM rate adjustment; 3) The current fully indexed rate (FIR) on his/her ARM; and 4) The no-cost rate on the FRM into which he/she can refinance in today's market.

Most borrowers know the ARM rate they are currently paying and when the rate will adjust, but few know the fully indexed rate. This is the most current value of the interest-rate index used by the ARM, plus the margin. The index used and the margin are both shown in the note, while the current value of the index is easily available online. Go to http://www.mortgage-x.com/general/mortgage_indexes.asp; it has them all.

The importance of the FIR is that it is the best available predictor of how your ARM rate will change. At the next adjustment date, the new ARM rate will reset to equal the index value at that time, plus the margin. [Note: usually there is a limit on the size of a rate change -- this "rate adjustment cap" can also be found in the note -- but in today's market the limit is seldom relevant]. If the index stays unchanged between now and then, the ARM rate at the next adjustment will be today's FIR.

This generalization has to be modified slightly for four indexes: COFI, CODI, COSI and MTA. Because these indexes lag the market, the best estimate of what they will be when your ARM rate is adjusted is their projected value 12 months ahead, not their value today. The mortgage-x site referred to above provides such projections for you.

The relevant FRM rate is the one you can command in today's market without incurring any refinance costs. Shop for a no-cost refinance at one of the better online sites, such as E-Loan or Amerisave.

Borrowers with an ARM can find themselves in any of four possible situations:

• Both the ARM Rate and the FIR Are Higher Than the FRM Rate: This means that the borrower is losing money now, and will continue to lose money after the next ARM rate adjustment. Conclusion: refinance immediately.

• Both the ARM Rate and the FIR Are Below the FRM Rate: This means that refinancing is a loser now, and will continue to be a loser after the next ARM rate adjustment. Conclusion: do nothing.

• The ARM Rate is Below While the FIR is Above the FRM Rate: This means that the borrower is saving money on the ARM now, but the situation will be reversed at the next ARM rate adjustment. Conclusion: wait until shortly before the rate adjustment date and then refinance.

  This is the most common situation. Some borrowers get spooked into hasty action by fear that rates will be higher in the future, which could happen, but rates could also be lower. My advice is not to give up the clear benefit of holding the ARM until the rate adjusts unless the current FRM rate is about the maximum the borrower can afford. In that case, the reward from hanging onto the ARM until the rate adjusts is outweighed by the risk.

• The ARM Rate is Above While the FIR is Below the FRM Rate: This means that the borrower is losing money on the ARM now but that the situation will reverse itself after the next rate adjustment.

  It is clear that if the borrower refinances in this case, it should be done immediately. What is not clear is whether the short-term savings from getting rid of the high-priced ARM now justifies giving up a lower ARM rate in the future. This is the one situation that requires my calculator 3e. And while the situation is uncommon today, it would quickly become common if rates begin another downward trend.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

Copyright 2006 Jack Guttentag