A friend recently called asking for advice on what to do with his Adjustable Rate Mortgage (ARM). His ARM is scheduled to reset in June of 2009. He has some time to think about this and I commend him for his foresight.

Now my friend can chose to gear up for a refinance into a fixed rate mortgage or he can just sit and wait to see how his rate adjusts later this year. While the refinance option may seem the most logical and safe choice – given the fall in home prices over the past few years, and the cost of a refinance – it may not be the most financially sound decision. On the other hand just sitting and waiting may be the more prudent choice at this point – because the rate may actually fall when the rate adjusts.

The most important thing to understand about an ARM is how the interest rate is derived as it resets. For most adjustable rate mortgage the final interest rate charged to the borrower is the sum of the index value plus the margin charged by the bank (Interest Rate = Index + Margin). In most cases the margin banks charge is fixed for the life of the loan. The number should be on one of the ARM disclosures in the closing packet you received when you closed on the mortgage. So, the variable which influences the final interest rate at the time of reset is the index.

There are many indexes upon which ARM’s are based. The more common ones are the 1-month LIBOR, the 6-month LIBOR and, the 1-year Constant Maturity Treasury Rate (CMT).  Again, the exact index used for your ARM is found in the disclosures you signed at the time of close. Once you know the margin and your index you can then very easily get an idea for how your rate could behave at the time of adjustment. Let me show you how.

For argument sake, lets say the margin on your ARM is 3.25% (fair to assume), and the index used is the 1-month LIBOR (a pretty common index). Which means if you obtained a 5 year ARM back in January 2004 when the 1-month LIBOR was 1.0982% (see chart below) your rate would have been 4.35%.

Now in January of 2009 the rate could be 0.58%. Which means instead of your ARM adjusting upwards you’ll actually see a fall in rate to 3.83%. This is a pretty big fall in rate (more than 0.50%). So your monthly payment is reduced without any closing cost expense and despite any loss in equity you may have recently experienced.

One word of caution is you need to know how often your rate can adjust. Some adjust monthly, others annually. In a time of falling index rates I personally do not see any cause for concern for at least the next 12-18 months. However, you have to be willing to stomach the uncertainty. Look at it this way, as  home prices bottom out and start to rise again, this may be your best way to avoid extra costs and ride out the market until things are on the upswing again.

For those interested in some hard core analysis on this topic, Mike Shedlock recently wrote about how the ARM reset problem has vanished into thin air.  Its a great read with a lot more analysis and thoughts on different indexes out there.