Whether they need cash for college or a HELOC for home repairs, homeowners refinance for many reasons. One of the most common reasons homeowners refinance their mortgage loans is to switch from a variable interest rate to a fixed interest rate. In this post, we outline the differences between an adjustable rate mortgage and a fixed rate mortgage. We also explain how mortgage borrowers can switch their monthly mortgage payments from variable interest rates to fixed rates. Follow below to learn everything you need to know about refinancing from a variable to fixed rate mortgage in 2022.
Terms to Know
Most readers have come to this post for one of two reasons. Some want to convert from a variable rate mortgage to a fixed rate mortgage. Others want to determine which type of loan is best for them. Whether you own a home or are hoping to buy in the near future, there are a few terms you should know first. From DTI to refinancing, here are a few terms to know before reading our post on switching from an adjustable to fixed rate mortgage.
Debt-to-Income Ratio (DIR)
In our recent post “Can You Get a Mortgage With Lots of Student Loans?,” we explained that mortgage lenders consider an applicant’s DTI. According to this resource from the Consumer Financial Protection Bureau, your DTI is “all your monthly debt payments divided by your gross monthly income.”
Gross monthly income is your total salary plus any other income before taxes are deducted. When calculating your DTI, lenders do not consider your overall debt. They consider your minimum monthly payments for each type of debt.
Lenders use this ratio to determine whether or not borrowers can afford the mortgage for which they have applied. Borrowers with an ideal DTI — typically below 36% — are more likely to be offered a low interest rate.
For a conventional mortgage, most brokers require a DTI of 43% or under. FHA, USDA and VA loan providers might lend to borrowers with higher DTI’s if they have a sizable down payment and good credit scores. If your income increases while your monthly debt payments remain the same or decrease, your DTI will appear more favorable to lenders.
Loan-to-Value Ratio (LTV)
The next term on our list is “loan-to-value ratio” or LTV. LTV is another metric by which mortgage lenders try to determine how risky their investment is. In a recent article for consumer credit reporting company Experian, Jim Akin explains. Akin writes that a loans LTV “measures the relationship between the loan amount and the market value of the asset securing the loan.”
Most lenders require a home inspection and appraisal before providing borrowers with a mortgage. If the appraisal value falls below the asking price, your mortgage lender might refuse to offer the loan. Usually, your lender will offer a mortgage that covers part of the asking price instead.
The amount they offer is typically determined by the LTV ratio they calculate, which is based on an appraiser’s report. Keep in mind that the LTV ratio does not include your down payment. Lenders will subtract your down payment from the amount owed and then divide that number by the asset’s appraised value.
Akins notes that “lenders and federal housing regulators are most concerned with LTV ratio at the time the loan is issued.” Because lenders use this metric to determine risk level, LTV will probably affect your loan’s interest rate.
Homeowners can “calculate LTV at any time during the loan’s repayment period.” There are two main reasons why the LTV falls over time. As you make regular monthly payments, the amount you owe decreases — as does the LTV. If the appraised value of your property goes up throughout the mortgage term, your LTV could also drop. On the other hand, falling property values could increase your LTV.
Another term current and future homeowners should know is “credit worthiness.” In a recent article for The Balance, Latoya Irby writes that “creditworthiness is a measure of how well you’ve handled your credit and debt.” Mortgage lenders will check your credit report to see how you have managed money — including prior loans — over the last few years.
Borrowers with high credit scores, low credit card balances and no late loan payments are more “creditworthy.” In short, your creditworthiness is an assessment of your approach to personal finance. Creditworthiness can be improved with a larger down payment, other assets — also called “collateral” — and co-signers with high credit scores.
As mentioned in the introduction to this post, homeowners refinance their original mortgage loan for a number of reasons. Some homeowners refinance to receive a lump sum of cash related to their home’s equity. Others need a HELOC or home equity loan to cover the cost of repairs.
Another reason homeowners refinance is to switch from an ARM to a fixed rate mortgage. Refinancing can provide homeowners with more favorable loan terms, including lower interest payments. This can result in lower monthly mortgage payments.
But what exactly is refinancing? In his article “What is a mortgage refinance, and how does refinancing work?” for The Mortgage Reports, Dan Green explains. Green writes that refinancing is “when a homeowner gets a new mortgage loan to replace their current loan.”
To refinance the existing mortgage, homeowners must apply for a new loan. This usually requires a new appraisal, home inspection and examination of the applicant’s creditworthiness. If approved, this new loan pays off your current mortgage balance. Most homeowners refinance to lower their monthly payments. However, “you can also refinance into a new loan type [or] shorten your loan term to pay off the home early.”
Fixed Rate Mortgages
A fixed-rate mortgage is a type of mortgage with an interest rate that never changes during the lifetime of the loan. Monthly mortgage payments are predictable. They are not subject to market fluctuations, nor are they determined by the current benchmark interest rate. In her article “What is a fixed-rate mortgage, and should you get one?” for Business Insider, Laura Grace Tarpley, CEPF explains in further detail.
Tarpley writes that with an FRM, “you still pay the same interest rate in 30 years as you did on your very first payment.” Your monthly obligation will remain consistent, “although US mortgage rates will increase and decrease over the years.”
Fixed rate mortgages are most desirable when interest rates are low. They are less desirable when interest rates are high. This is because borrowers are stuck with that higher interest rate for the lifetime of their loan unless they opt to refinance.
Adjustable Rate Mortgages
With an adjustable rate mortgage — also called a variable rate mortgage — your monthly mortgage payments are subject to change as US mortgage rates fluctuate. For a fixed period of time, your loan payments reflect the “introductory interest rate.” During this time, your interest rate remains unchanged and your monthly payments remain predictable.
Your first monthly payments might even be quite a bit lower than if you had taken out a fixed rate mortgage instead. As James McWhinney writes in an article for Investopedia, the “initial interest rate…is set below the market rate on a comparable fixed-rate loan.”
However, once the fixed rate period expires, the interest rate changes “at a pre-arranged frequency.” Most ARM interest rates reset each year. If you hold onto your adjustable rate mortgage for long enough, your interest rate will eventually “surpass the going rate for fixed-rate loans.” When considering variable rate mortgages homeowners must be able to budget for significant swings in their monthly payments.
Are ARMs Risky?
Because your obligation could increase substantially from one loan reset to the next, a variable rate mortgage can be risky. Quoting CFP David Mendels in an April 2022 article for CNBC, Sarah O’Brien outlines these risks. Mendels notes that “‘there is a lot of variability…as to how much the rates can go up and how quickly.'”
As interest rates are still close to historical lows reached during the pandemic, ARM rates are likely to go up — not down. O’Brien writes that this “makes an ARM a riskier proposition than a fixed-rate mortgage.” When considering an ARM, homeowners should budget for “a maximum increase” in interest rates — not just a “1% or 2% increase.”
If possible, provide your lender with a larger down payment. Quoting mortgage broker Stephen Rinaldi, O’Brien explains why. Rinaldi tells O’Brien that a larger down payment insulates you from fluctuations in the market that could increase your LTV. According to Rinaldi, the market could “‘correct for whatever reason and home values [could] drop.'” If this happens, “‘you could be underwater on the house and unable to get out of the ARM.'” To this point, brokers usually recommend borrowers pick an FRM instead of an ARM if the value of the home is less than $200k.
The next few terms defined in this list describe features of adjustable rate mortgages. Amortization refers to the rate at which you pay off your mortgage. This schedule details the amount of interest and principal you will pay in each monthly installment. With an ARM, your monthly payment amounts will fluctuate as the loan’s interest rate changes. However, the frequency of the loan reset in a fully amortizing ARM is predetermined by your broker and laid out in your loan terms.
In some cases, borrowers might choose an interest-only ARM. An interest-only ARM is different from a fully amortizing ARM. This means, that borrowers only pay off the interest they owe on the loan each month. While this lowers your monthly payment, it also produces a massive “balloon payment” at the end of the loan term.
With an FRM, you pay the same amount each month, but the ratio of interest to principal changes over time. In an article for NerdWallet, Holden Lewis writes “the gradual shift from paying mostly interest to mostly [principal] is the hallmark” of an ARM.
Another feature of adjustable rate mortgages, “adjustment frequency” is how often the loan terms reset once the fixed-rate period has passed. In most ARMs, this happens once a year but the frequency differs from one brokerage to the next. Writing for Investopedia, Julia Kagan notes that “adjustment frequency is an important but potentially overlooked feature” of ARMs.
Borrowers should pay particular attention the adjustment frequency outlined in their contract, as this could impact their overall debt obligation. According to Kagan, “a longer period between rate modifications is more favorable to the borrower.” This is because “the less often the rate is adjusted, the less often the borrower is exposed to the risk of upward movement.”
Introductory, Initial or Teaser Rate
As mentioned above, an ARM’s initial interest rate is usually lower than that of an FRM. The lower fixed rate borrowers benefit from during the first couple years of their loan is called an “introductory,” “initial” or “teaser” interest rate.
The fixed rate period of an ARM usually lasts three to ten years, depending on the loan term. Mortgages with shorter loan terms typically have shorter fixed rate periods.
In your home loan contract, your mortgage broker will define several adjustment caps. These dictate how high your interest rate can go during the lifetime of the loan. With an ARM, there are three types of adjustment caps. According to the Consumer Financial Protection Bureau (CFPB), these include an initial adjustment cap, subsequent adjustment cap and lifetime adjustment cap.
The initial adjustment cap determines “how much the interest rate can increase the first time it adjusts after the fixed-rate period expires.” A subsequent adjustment cap determines “how much the interest rate can increase in the adjustment periods” following the first adjustment after the fixed-rate period. The lifetime adjustment cap determines “how much the interest rate can increase in total, over the life of the loan.” This is usually somewhere around 5%.
Why Do Interest Rates Matter?
Mortgage rates matter because they impact how much you owe as part of your monthly mortgage payment. With an FRM, mortgage interest rates are fixed, but with an ARM they are variable. In most cases, interest makes up a larger percentage of your monthly payments in the beginning. Towards the end of the loan, you pay more principal than interest.
As the benchmark rate increases, mortgage interest rates also rise. This can make an ARM unaffordable for certain homeowners. If their payments become too expensive, homeowners might choose to switch from a variable to fixed rate mortgage.
Is It Possible to Switch from a Variable to Fixed Rate Mortgage?
Homeowners can switch from a variable mortgage to a fixed-rate mortgage, but not without replacing their current loan. This requires homeowners to refinance their existing mortgage. Most ARM homeowners weighing a refi consider switching to a fixed-rate mortgage towards the end of their teaser rate period. They hope to benefit from the comparatively low initial rate while avoiding the expensive increases in US mortgage rates that might follow.
Though refinancing from a variable to fixed-rate mortgage could lower your monthly mortgage payments, it can still be a costly endeavor. For example, replacing your current loan with a brand new 30-year mortgage could mean more monthly mortgage payments when all is said and done. You could end up paying more in total than you would have with your ARM. Plus, homeowners who receive a new loan — either from their current lender or another broker — have to pay closing costs all over again. Is switching from a variable to fixed rate mortgage the right choice for you? We weigh the pros and cons below.
Should You Refinance From an ARM to a Fixed-Rate Mortgage?
For certain homeowners, switching from an ARM to an FRM is the right choice. This is because interest rates are expected to rise even further by the end of this year. If you are nearing the end of your introductory rate period, your monthly interest payments could jump considerably in 2023.
In an April 2022 article for Bankrate, David McMillin elaborates. He notes that while mortgage rates have already risen, “it still might be a good idea to switch to a fixed rate.” The consistency and predictability of monthly payments in a fixed-rate mortgage can offer homeowners peace of mind while helping them budget. If you have a high credit score, some equity in your home and enough cash to afford closing costs, a refi might be best.
Homeowners should also consider how long they plan to stay in their current home when weighing a refi. Those who plan to sell soon might not benefit from taking out an entirely new loan. The closing costs involved in a refi could be too expensive to justify refinancing when one hopes to sell soon.
If you are still unsure about whether refinancing is the right choice, discuss your options with a financial advisor. They will explain your current loan terms and make recommendations based on your financial health and the caps outlined in your contract.