Stick with adjustable rate mortgage?

Question: My wife and I have an Adjustable Rate Mortgage on our home with a current interest rate of 6.125%. We recently received two letters from the lender presenting us with two options. The first is to accept an interest rate adjustment which would decrease the rate to 4.125% and lower our mortgage payment by about $300 / month. The second option is to convert the loan over to a fixed rate mortgage with an interest rate of 5.00% for a one time fee of $250. This would decrease our current loan payment by $175.00 / month.

We will also have the option to convert the mortgage next year. My question is should we wait on converting the loan to a fixed rate and take advantage of the 4.125% interest rate for the next 12 months, and convert next year and hope to get a decent fixed interest rate. I know we are taking a gamble on the interest rates a year from now, but having an extra $300 / month for the next to put toward our savings would be pretty nice. Paul, Olive Branch, MS

Answer: Boy, the trade-off between risk and reward would push me to grab a fixed rate mortgage at 5%. That's an attractive rate. The $250 conversion fee is minimal. Once you have locked in the fixed rate it doesn't matter how high rates go in coming years. You're protected. If rates trend lower, you can always refinance. I wouldn't minimize the risk of higher interest rates when it comes time to reset the rate next year.

The savings aren't great with the ARM anyway. If you stick with the ARM you'll have an extra $3,600 for the year. That's a nice piece of change. But if you convert to the fixed rate mortgage you'll still have improved your yearly cash flow by $1,850 ($175 a month in savings minus the $250 fee). And you will have locked in that extra monthly cash cushion. So, for an extra $1,750 (he difference between your savings with the ARM and the fixed rate) you're accepting the risk of a higher rest rate a year from now. There's no guarantee the lender will offer the same deal, either. It doesn't seem worth it to me to stick with the ARM.

Why gamble? Our money lives are difficult enough these days. There is a lot to be said for grabbing for some financial certainty.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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