Reasons to Change Your Mortgage Program When You Refinance

By Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience

Edited by Michael Jensen, Mortgage and Finance Guru

Updated November 6, 2020

One potential reason to refinance your mortgage is to change loan programs.  You may have a loan program such as adjustable rate mortgage (ARM) or interest only loan that involves higher risks and potential payment shock.  For example, one of the biggest risks of an ARM is that your monthly payment increases significantly if interest rates rise.  Refinancing an ARM into a fixed rate mortgage can protect you against potential future monthly payment increases and potentially save you thousands of dollars in interest expense over the life of the loan.  It is highly challenging to predict mortgage rates but if you think rates are going to increase and you have an ARM or an interest only loan, it may make sense to refinance into a fixed rate mortgage to avoid a possible payment spike and to gain more financial certainty.

Refinancing an ARM or interest only loan into a fixed rate mortgage provides certainty and can save you thousands of dollars in the long run 

Because the initial interest rate for an ARM or interest only loan is typically lower than the rate for a fixed rate mortgage, you may have a higher monthly payment for the first several months or years after you refinance, depending on how rates today compare to rates when you obtained your original mortgage.  If interest rates increase over time, however, the monthly payment on the fixed rate mortgage does not change while the payment on the ARM or interest only loan could continue to rise.  So in the short term refinancing into a fixed rate mortgage may cost you more due to closing costs and a higher monthly payment, but over time, refinancing to change your mortgage program should result in a lower monthly payment as compared to not refinancing, reduced total interest expense and the peace of mind that comes from knowing that your monthly payment is fixed.

The rationale for refinancing to change your mortgage program works both ways.  Although less common, some borrowers may benefit from refinancing a fixed rate mortgage into an ARM or interest only loan.  For example, if you obtained your loan when interest rates were high, you may be able to refinance into a lower rate and reduce your monthly payment by switching from a fixed rate mortgage to an ARM or interest only loan.

• Use ourMORTGAGE REFINANCE CALCULATORto determine if you should refinance

These mortgage programs may also enable you to qualify for a higher loan amount which may be another reason to switch programs when you refinance, especially if you are looking to take cash out of your home. Additionally, if you believe mortgage rates are going to decline, then an ARM or interest only mortgage may enable you to benefit from a lower monthly payment in the future as compared to a fixed rate loan with a payment that never changes.  Forecasting mortgage rates is highly challenging so borrowers should exercise caution with this approach. The last thing you want is to refinance into an ARM or interest only loan and then not be able to afford your mortgage and monthly payment in the future.

The table below compares interest rates, APRs and closing costs for fixed rate mortgages.  We recommend that you contact multiple lenders in the table to request refinance proposals.  Comparing lenders and loan programs enables you to find the best refinance terms including the lowest rate and fees.

The example below demonstrates the benefits of refinancing an adjustable rate mortgage into a fixed rate loan in an increasing interest rate environment.  The benefits include a lower mortgage rate and monthly payment over the majority of the new fixed rate mortgage as well as reduced total interest expense.  In the example, the original mortgage is a 7/1 ARM that the borrower refinances at the end of year five.  The mortgage rate on the original loan is fixed for the first seven years and then is subject to adjust on an annual basis in years eight through 30 of the mortgage, which exposes the borrower to significant risk if interest rates go up.  Full details of the original 7/1 ARM and new fixed rate mortgage are below:

For the purpose of this example, we show the fastest possible increase in the mortgage rate for the ARM during the loan's adjustable rate period until the rate reaches its life cap in year eight and remains at that level until the end of the loan.  While this is a pretty drastic example, it effectively shows the possible risks an ARM as well as the reasons to refinance into a fixed rate mortgage.  We compare this scenario to a case when the borrower refinances the ARM at the end of the fifth year into a 30 year fixed rate loan with an interest rate of 5.000%.  The principal amount of the mortgage does not change when the loan is refinanced.

The chart below compares the monthly payment and total interest expense for the original 7/1 ARM with the new 30 year fixed rate mortgage.  In short, the chart enables you to review the outcome if the borrower did not refinance.  Initially, refinancing is more expensive for the borrower -- in years six and seven the interest rate and monthly payment for the fixed rate mortgage are higher than for the ARM.  However, as the mortgage rate increases when the ARM enters its adjustable rate period in year eight and beyond, the fixed rate mortgage offers the borrower a lower monthly payment and significantly reduced total interest expense as compared to the original loan.

By refinancing into a fixed rate loan at the end of year five, the borrower gains certainty over his or her monthly payment, reduces his or her monthly payment by $425 in years 8 through 30 of the loan and saves a total of $76,224 in interest expense over the life of the mortgage. While this example shows the most extreme scenario for the adjustable rate mortgage, it also demonstrates the significant benefits of refinancing to change mortgage programs, especially if you think rates are going to rise.

Below we present results from the example in table format.  Using the same assumptions, the table compares the original 7/1 ARM to a refinanced 30 year fixed rate mortgage put in place at the beginning of year six.  The table illustrates the monthly mortgage payment savings that begin in year eight as well as the reduction in total interest expense realized by refinancing.  In the example, even though the borrower extends the original mortgage term five years, by refinancing and changing loan programs, the borrower lowers his or her monthly payment beginning in year eight and reduces total interest expense by almost $80,000.

Use our free personalized mortgage quote form to review no obligation refinance quotes. Our quote form is easy-to-use, requires minimal personal information and does not affect your credit. Comparing multiple proposals is the best way to save money when you refinance.

Sources

"Determining Whether to Refinance."  My Home by Freddie Mac.  Freddie Mac, 2019.  Web.