Refinancing Strategies

When your adjustable-rate mortgage is adjusted.

September 10, 2007
Sponsored by Wells Fargo

Part 1 in a two-part series

Facing the reality of interest-rate adjustments on your adjustable-rate mortgage (ARM)1 can cause various reactions — from concern over your ability to make new payments to a desire to search for alternatives.

The following information can guide you through this adjustment, assisting you in evaluating your options and dealing with your concerns.

What's Behind the Change?

If you have an ARM, you probably selected it because it offered a lower initial interest rate. This lower initial rate:

  • Increased your borrowing power
  • Provided you with initial lower monthly payments than you would get from a fixed-rate mortgage

However, that low initial rate doesn't stay that way forever; it's scheduled to change periodically. When and how often it changes depends on the type of ARM you selected:

  • The initial interest rate can remain fixed for the first one to 10 years. After that, it can adjust periodically based on financial market conditions and the type of loan you have.
  • During the initial fixed-rate period of your ARM, your monthly payments are typically lower than those of a fixed-rate loan.
  • After the fixed-rate period expires, your loan will adjust according to the frequency scheduled in the ARM product you have and the current market conditions. Some ARMs will adjust every six months while others may adjust every five years.

Consult your loan agreement for details about how the adjustments are determined, the frequency of adjustments to your interest rate, and the maximum amount the interest rate can increase over the life of the loan.

Evaluating the Equity Effect

Because your home is likely your most valuable financial asset, it's critical that you take steps to protect your investment. This is an important perspective to maintain now, when you might be tempted to focus only on the more immediate effects of a change to your monthly payment.

While it's necessary to have a monthly payment that fits within your budget, it's important to pay some amount of the loan's outstanding balance — known as principal — each month.

Your monthly mortgage payment consists of two components: principal and interest.

  • Principal is the amount that reduces the outstanding loan balance
  • Interest is the fee charged for using this borrowed money

Loans that permit you to pay only the interest component — or just a portion of the monthly interest payment — have become quite popular. Because these loans with the Interest-Only payment feature2 don't include the principal portion of your payment, the low monthly payments they offer can appear quite attractive.

But remember: Having a manageable monthly payment is only part of the equation. You also have to consider the long-term effect of your loan. Let's look at some of the effects of these loans.

Loans that permit Interest-Only payments

  • If you don't make principal payments, you lose the ability to increase your home’s equity by decreasing your loan's outstanding balance.
  • When the interest-only period expires, your payments can increase substantially because the remaining balance is repaid over a shorter period of time. For example, if you have a five-year loan with the Interest-Only payment feature, your principal is amortized over the remaining 25 years.
  • If property values decline, you could owe more than your home is worth.

Loans with payments that are less than your full monthly interest payment

  • When your payments are less than the interest due each month, the unpaid interest is added to your loan's unpaid balance.
  • When you repeatedly make monthly payments that don't cover the interest incurred each month, it's known as negative amortization because you're increasing the amount of your loan.
  • Regularly making these minimum payments could result in owing more than your home is worth.
  • When these loans — which are called option ARMs — are adjusted, they typically increase to rates that are higher than traditional ARMs.
  • In some cases, rate increases can cause payments to rise by nearly 25 percent.

How do you know if your mortgage is an Interest-Only or option ARM? Take a look at your most recent mortgage statement, and use the information to answer this question: Is your outstanding balance higher or lower than the amount you originally borrowed?

  • If your balance is lower than what you originally borrowed, you're building equity and adequately protecting this important financial asset.
  • If your balance is higher or exactly the same, you should consider taking steps to protect your most-important asset by refinancing.

In most cases, Interest-Only or option ARM loans are best viewed as "transition mortgages." As soon as you can manage a larger payment, consider making additional payments to principal or refinancing into a loan that includes regular principal payments.

Learn More

If you have questions about your loan, experienced mortgage consultants from the AICPA-Sponsored Home Mortgage Program and Wells Fargo Home Mortgage are available. Call 1-800-CPA-1210 for more information or conduct a free break-even analysis online.

Stay tuned for next month’s CPA Insider, which will feature more information on refinancing strategies when your ARM resets, including Considering Your Options and Dealing with Concerns.

1. Rates may vary and are subject to increase after consummation. 2. The Interest-Only payment feature will allow you to make minimum interest payments for a set period of time, then full principal-and-interest payments for the rest of your loan/line term. At the end of the interest-only period, you will be required to pay down the outstanding principal, which will increase your monthly payment, possibly substantially, even if you have a fixed interest rate. Always consider making more than the minimum payment during the interest-only period to begin reducing principal. Depending on the product specifics, a loan/line with the Interest-Only payment feature may result in higher interest rates or Annual Percentage Rates than a traditional mortgage product. Wells Fargo Home Mortgage is a division of Wells Fargo Bank, N.A.

© 2007 Wells Fargo Bank, N.A. All rights reserved. #49800 7/07-10/07 Equal Housing Lender.