You may want to convert an adjustable-rate mortgage (ARM) to a fixed-rate loan to gain stability in your monthly payments or in the event that interest rates drop faster than your ARM can accommodate. Many ARMs have caps limiting the amount of periodic adjustments. So, if interest rates drop 3 percentage points in a year but your ARM has a 2 percent annual cap, you may want to refinance to take full advantage of the new, low interest rates.
When interest rates drop, you can refinance to take advantage of the new rates, getting either a new ARM or a fixed-rate mortgage at a lower rate. When you replace an old ARM with a new one, you generally reset your mortgage's lifetime adjustment cap. For instance, if your old mortgage had a lifetime adjustment cap of 6 percent and the initial rate was 10 percent, your mortgage rate could go as high as 16 percent. If you replace your old mortgage with an ARM with a rate of 8 percent and a lifetime adjustment cap of 6 percent, your mortgage interest rate will never go higher than 14 percent.
Reducing the interest rate on your loan is usually a good reason to refinance a mortgage. In order to take advantage of new rates by refinancing, however, you sometimes must have a minimum equity of 10 percent in your home.
Refinancing provides the added opportunity to either reduce or extend the term of your loan. Say you have 20 years left on a 30-year loan at 10 percent interest. You learn that you can get a new, 30-year loan for the outstanding principal at 8 percent interest and save $250 per month on your payments. But, you also learn that you could pay off your loan faster by continuing to pay about the same amount each month on a 15-year mortgage. This latter option could be a good choice in certain circumstances—for example, if you are nearing retirement.
If you choose to get a new mortgage with a longer term, you may simply be happy making the lower payments each month. On the other hand, you may want to continue your payments at about the same level and take a larger mortgage loan, taking some cash out of the equity you've built in your home. People take equity from their homes for many reasons; one of the best of these is debt consolidation. When you refinance a mortgage to consolidate credit card debt, for instance, you usually replace high-interest credit card debt with a low-interest mortgage debt. Beware that some lenders require you to retain at least 25 percent equity in your home when you refinance for debt consolidation.
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