23 Jun Should I lock in a fixed-rate mortgage?

Q. I have an adjustable rate mortgage from two years ago at 4.85 percent interest. I’m wondering if I should make it a fixed loan now or wait? I don’t plan to move any time soon.
— Homeowner

A. The interest rate attached to your mortgage is a critical factor in determining the total cost over the life of your loan.

Mortgages come in many different shapes and sizes, said Chadderdon O’Brien, a certified financial planner with RegentAtlantic in Morristown.

He said adjustable rate mortgages, also called ARMs, have an interest rate that can change over the life of the loan.

“In the early years, typically the first five or seven, the rate is fixed at a rate that is often lower than a comparable fixed rate loan,” he said. “After the initial five or seven year period is over, the fixed rate becomes variable and adjusts based on changes to the underlying index that the loan is benchmarked to.”

He said your loan document will outline how the rate change is calculated.

With an ARM, Depending on the interest rate environment, mortgage payments can increase or decrease over time, O’Brien said.

A fixed rate mortgage, on the other hand, locks in the interest rate and associated principal and interest payments for the life of the loan, typically over a 15 or 30 year time period, he said.

Now to your question about which is a better option today.

O’Brien said the current rates associated with a standard 30-year fixed rate loan are lower than at any point over the past 25 years, excluding a short period of time in 2013.

Additionally, he said, the Federal Reserve has all but guaranteed its intentions of gradually increasing interest rates over time.

“Mortgage rates will be sensitive to these changes and will also increase over time,” O’Brien said. “Locking in a fixed rate now may prove to be a prudent long term decision.”

For the week ending May 20, 2016, the average rate on a 30-year mortgage was only 3.85 percent. O’Brien said the opportunity to lock in a fixed rate that is currently below your adjustable rate is an attractive one.

“The long term benefits of this may be even more pronounced if your current rate adjusts upward in the future,” he said. “By refinancing now, you will likely reduce the total interest expense over the life of your mortgage.”

Refinancing does, however, come at a cost. The question next becomes how long will it take to recover those costs?

Knowing that you do not plan to move any time soon is valuable information,” O’Brien said.

He gave this example:

Without knowing the specifics of your loan, let’s assume you incur $3,000 in closing costs to refinance your adjustable rate mortgage into a 30-year fixed rate mortgage. Let’s also assume your outstanding mortgage balance is $400,000. If the current mortgage is a five-year adjustable rate loan, your monthly principal and interest payments will be around $2,100. If we convert the $400,000 loan into a 30-year fixed rate loan at 3.9 percent then the monthly principal and interest payments would be roughly $1,900.

“When we compare the two monthly payments, the break-even period to recover the $3,000 in closing costs amounts to approximately 15 months,” he said. “If you continue to live in your house for a period longer than 15 months, you will have likely recovered the refinance costs vis a vis lower monthly mortgage payments.”

Additionally, O’Brien said, you will have locked in a low rate for the remainder of your loan while avoiding a potentially higher rate when your rate adjusts in the coming years.

He said a 15-year loan will carry an even lower interest rate, however, your cash flow will need to support the higher monthly payments. You can take your current mortgage payment and compare it to refinancing estimates to get a better idea of your specific breakeven period.

“Whether you decide on a 15- or 30-year refinanced loan, now is a good time to consider locking in a lower rate, O’Brien said.

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This post was first published in June 2016.