What to Do When Your Adjustable-Rate Loan Resets

Homeowners who opted for an adjustable-rate mortgage (ARM) when interest rates were near historical lows may now be confronting the possibility of their loans resetting at a much higher rate. 

A key attraction of an ARM is that they generally come with a fixed interest rate for a specified initial term—five years, say—after which the interest rate may reset in line with prevailing interest rates (based on the terms of the loan). Generally, the initial fixed rate is lower than what you'd pay for a fixed-rate mortgage, making ARMs an appealing option for homebuyers who expect rates to fall in the future or maybe expect to sell their homes before rates reset.

Of course, if rates go the other way—as they have after plumbing historical lows just four years ago before bouncing sharply higher—then a rate reset prove painful, leading to a potentially sharp jump in your mortgage-financing costs. 

So, what can you do in such situations? Here are some possibilities. 

First, familiarize yourself with the mechanics of your loan. After the initial fixed-rate period ends, your rate will adjust at set intervals, typically every six or 12 months. This new rate generally is calculated using two numbers: an adjustable market-based interest rate, often the Secured Overnight Financing Rate (SOFR), plus a fixed margin that was set when the loan was established. For example, a 3% SOFR plus a 2.5% margin results in an adjustable rate of 5.5%.

However, most ARMs have a series of interest-rate caps to protect you from exorbitant rate increases:

• An initial cap, which limits how much your payment can go up when your initial fixed-rate period ends.
• A periodic cap, which limits the size of the rate increase at each adjustment.
• A lifetime cap, which establishes a maximum interest rate for the life of the loan.

Understanding how these caps work is essential because they define the worst-case scenario for your borrowing costs once your ARM resets. 

Once armed with your loan information, you can properly evaluate your options. Here are five approaches to consider: 

1. Do nothing: It's possible, given the current mortgage-rate environment, that an ARM secured a few years ago with attractive terms might still be your best option even after the initial fixed rate ends. Sometimes a good cap structure can save you.
2. Refinance: If you have sufficient equity and a strong financial profile, refinancing into a new loan could make sense. Depending on your goals and current interest rates, you could opt for another ARM or pursue a fixed-rate mortgage. The former will help you secure a smaller initial payment while the latter will offer predictable payments for the life of the loan. However, closing costs are a key consideration when deciding whether to refinance, especially if you pay "points"—a percentage of the loan amount—to secure a lower interest rate. It can often take years to break even on those costs, so work with your financial advisor to compare the financial impact of a refinance against the worst-case cost scenario on your current ARM.
3. Pay down the loan: If you make a lump-sum partial payment to the loan's principal ahead of a rate reset, the bank will re-amortize the loan based on the lower amount outstanding, which can help keep your monthly payment manageable even if your rate adjusts higher. However, when you have ample liquid assets, the question isn't whether you can pay down your loan but whether you should. Generally, if you can earn more in the market than what you're paying in interest, it might make more sense to invest the assets than to pay down your debt.
4. Convert your loan: Some ARMs come with a conversion feature that allows you to switch to a fixed rate when the initial rate period ends. However, you'll need to see how the conversion fees and other costs, plus the resulting fixed rate, compare to just refinancing.
5. Move. As noted above, many homebuyers use an ARM when they don't expect to hold the property for the long term. If a move is still in the cards, the up-front cost of refinancing now might not be worth it.

Before making a decision, consult with your financial advisor, who can help ensure your mortgage strategy aligns with your broader wealth-management goals.