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05/25/2008
Is it time to refinance my
option ARM? It's a great question but not so simple to answer accurately.
Here are some important considerations:
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Negative amortization (deferred interest)
This is the amount of money that is added to the balance of your loan if you
elect to pay less than an interest only payment option. Many people
hate this aspect of the Option ARM but of course if the full interest is
paid every month there will never be any negative amortization. Other
borrowers wait until close to the end of the year and then pay down the
negative amortization for a tax write-off. Consult your tax
professional, some lenders do not itemize the deferred interest separately,
it gets added back to the principal balance. Keep in mind that if you
pay all of the interest, you may be making a higher payment.
So, the bottom line of the negative amortization issue is one of personal
preference, it is neither good nor bad in itself and is easily avoided.
A final thought, when rates are dropping and your payment rate is higher
than a fully amortizing payment, you will have accelerated amortization.
This means, not only do you not incur negative amortization but your loan is
paying off faster than a normally amortizing loan. Accelerated
amortization can help take the sting out of any previous negative
amortization.
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Adjustable rate
Most Option ARM loans are adjustable and most adjust monthly which can
result in the above mentioned negative amortization. If your loan does
adjust monthly it should be tied to a relatively slow moving index such as
the 12MTA (12 Month
Treasury Average) or
COFI (11th District Cost of Funds Index).
Other indexes may be suitably slow moving for a monthly adjusting loan.
Whether or not you should keep an adjustable rate mortgage depends on where
you think we are in the interest rate cycle, what is your current rate, what
is the maximum rate of the loan and your own personal tolerance for risk.
Another consideration is your own spending habits, do you always pay the
minimum payment or do you pay extra to cover all of the interest? If
you normally just pay the minimum payments and allow negative amortization
to accrue, how do you spend the money saved by making lower payments?
If those funds are regularly applied to paying off higher interest debt then
perhaps keeping the Option ARM is the best choice.
Evaluating your Option ARM
If you just can't stand the possibility of negative amortization or
adjustable rates then of course it is time to refinance. Peace of mind
is worth the costs of refinancing. If those issues do not cause you
great concern then it's time to evaluate your loan to see if it really makes
sense to refinance your mortgage.
Since Option ARMs adjust by adding an index value to a fixed margin then the
amount of margin is most important. Index plus margin equals your
fully indexed true rate, regardless of the payment rate. A loan can
start at a 1% payment rate and begin accruing interest at 8% the first day
of the loan. If your index plus margin is higher than the current 30
year fixed rate then it would seem to be the right time to
consider a refinance. If you still need lower payments than the 30
year fixed rate loan provides then consider an ARM which is fixed for the first 5, 7 or 10 years.
Caveat - some Option ARMs were originated with pre-payment penalties up to 3
years. Read your loan closing documents.
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