If you’re planning to buy a house, you can choose a fixed-rate loan or an adjustable-rate mortgage (ARM). If you decide to go with an ARM, the interest rate will change in the future. You may be able to refinance to avoid a higher rate, but there are no guarantees.
How Does an Adjustable-Rate Mortgage Work?
An ARM has a low interest rate during an introductory period that lasts for several years. After that, the interest rate resets periodically based on market conditions at the time. The rate may rise or fall, and monthly mortgage payments may go up or down, depending on what’s going on in the market at that time.
Some buyers choose an adjustable-rate mortgage to take advantage of a low initial interest rate. They reason that if their rate is likely to rise, they can refinance before the rate resets and switch to a fixed-rate mortgage with a low interest rate. That strategy may or may not work.
Why You May Be Unable to Refinance
When you apply to refinance your mortgage, the lender will look at your financial circumstances at that time. Even if you got approved for a mortgage several years earlier, you can get denied when you try to refinance.
Your credit score can go down if you make late payments, accumulate more debt or have a derogatory mark, such as a bankruptcy, on your credit report. A credit score that doesn’t meet the lender’s criteria can get your refinance application rejected.
A lender will look carefully at your debt-to-income ratio, or the percentage of your monthly income that goes toward debt payments. If you rack up credit card debt or take out a car loan, your debt-to-income ratio when you want to refinance may be higher than it was when you initially took out a mortgage. If it’s too high, your application can be denied.
The value of your house is also important. Sometimes market conditions cause home values to drop. A lender wants to make sure that it isn’t issuing a loan for an amount that’s more than a property is worth. If the amount you want to refinance is higher than your home’s market value at that time, a lender may deny your application for a new mortgage.
You Can’t Predict the Future
Adjustable-rate mortgages are attractive to many buyers because of their initial low rates. It’s often possible to refinance to avoid a higher interest rate later on, but sometimes it isn’t. If you take out an ARM and then you can’t refinance, you can get stuck with a mortgage at a higher interest rate.
You have no way to know what the housing market as a whole will be like years from now. You also don’t know if you will incur more debt because of a job loss or another misfortune. Think carefully about whether you’re willing to take the risk or whether you would feel safer with a fixed-rate mortgage.
