How to Refinance an Adjustable-Rate Mortgage into a Fixed-Rate Mortgage

Buying a home through mortgage financing is one of life's most significant financial commitments. Each year, it is likely that you will fork over several thousands of dollars in interest payments to the bank. For relief from these expenses, you may consider mortgage refinancing. Refinancing an adjustable-rate mortgage (ARM) into a fixed-rate mortgage does require you to maintain special knowledge of Federal Reserve policy and the interest rate environment.

Mortgage Refinancing

Mortgage refinancing describes a series of transactions where you take out a new loan and apply the cash proceeds to pay off an existing mortgage balance. When exchanging an adjustable-rate mortgage for a fixed-rate mortgage, your goal remains to lock in a relatively low interest rate and manage interest rate risks. An adjustable-rate mortgage features a variable rate structure that shifts alongside the prevailing economic environment, while a fixed-rate mortgage charges the same interest rate throughout its term. As a conservative buyer, you would prefer a fixed-rate mortgage to plan your budget around regular housing payments.

Federal Reserve Board

You will monitor Federal Reserve Board policy to anticipate shifts within interest rate trends, before you make the decision to refinance an adjustable-rate mortgage into a fixed-rate mortgage. To do so, you will track the federal funds rate, which is a benchmark for all interest rates. Banks make overnight loans to each other at the federal funds rate--so that each bank can meet its Federal Reserve requirements. For mortgage loan offerings, banks will charge a premium above the federal funds rate as compensation for taking on the increased risks of dealing with consumers relative to other financial institutions. In recession, you can expect the Federal Reserve Board to lower interest rates, in order to encourage people to take out loans, purchase big-ticket items, and invest money to stimulate the economy. When the economy recovers, the Fed will drive interest rates higher to guard against inflation risks.

An adjustable to fixed-rate mortgage refinancing works best when rates are actually on the rise. After the refinancing, you will lock in a level interest rate and effectively avoid ARM payment shock. ARM payment shock occurs when your monthly mortgage payment becomes unaffordable -- due to a significantly higher interest rate.

Refinancing Costs

When refinancing, you may be subject to both closing costs and pre-payment fees. Pre-payment fees on your old mortgage are in place to discourage you from paying off the loan early through refinancing. By law, your lender is required to disclose the presence of any pre-payment fees within your mortgage contract. For example, you may owe nine months worth of interest payments, if you pay off the mortgage in full within its first three years. In addition to these prepayment fees on the old mortgage, you will owe closing costs on the new mortgage. According to the Federal Reserve Board, you can expect to pay 3 percent of your new mortgage principal in closing costs. The bank levies these closing costs, so that it can perform services that protect its best financial interests and evaluate your credit worthiness. Your closing costs therefore go toward a home appraisal, title insurance, credit check, and legal fees.

Strategy

Before refinancing your ARM into a fixed rate mortgage, you should verify that your future savings will exceed your up-front closing and mortgage pre-payment costs. To do so, you will pull up an online mortgage calculator and toggle through cost and interest rate projections. With an adjustable to fixed-rate refinancing, your projections will be further complicated by the fact that that your ARM rate may swing dramatically from year-to-year. As a good rule of thumb, however, you will come out ahead if you can lower your current mortgage interest rate by 1 percent and plan to own your home for at least the next 10 years.

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