Rising interest rates are shutting more homeowners out of refinancing a mortgage and are keeping more first-time home buyers out of the market, according to research reports on mortgage applications. And things aren’t expected to get any better this year.

That’s because the Federal Reserve raised interest rates in March to their highest level in a decade, and has signaled it plans to raise rates at least twice more in 2018. An increase in the federal funds rate is regularly mirrored by similar interest rate increases in home loans.

An adjustable-rate mortgage, or ARM, is often a good way to refinance a mortgage because an ARM’s short terms of five to seven years allows it to have lower interest rates than a 30- or 15-year fixed-rate mortgage. Rising interest rates, however, are taking away that gap and could potentially lead to higher rates for borrowers who refinance into an ARM.

Refinancing drops

In the first six weeks of 2018, about 1.4 million borrowers lost the interest rate incentive to refinance their home loans, according to a report by Black Knight, a data analytics company. That’s a huge increase since the final 12 weeks of 2017, when 120,000 people were unable to get into a cheaper loan product, the report found.

Higher interest rates has lowered the population of borrowers who can save money by refinancing their mortgages by close to 40 percent in 40 days, Black Knight reported.

There are still 2.65 million homeowners who could still benefit from refinancing their mortgages, which is the smallest that population has been since late 2008 when interest rates started dropping, the firm says.

The number of refinance originations dropped 29 percent in 2017, Black Knight reported. More recently, the Mortgage Bankers Association reported that as of April 6, mortgage refinances dropped to its lowest level since September 2008, with 38.4 percent of total applications for refinancing, and 6.3 percent for ARMs.

The association reported these average interest rates for loan balances of $453,100 or less as of April 11:

• 30-year fixed: 4.66% for loans with conforming balances
• 30-year fixed: 4.53% for jumbo loans
• 15-year fixed: 4.08%
• 5/1 ARM: 3.93%

Understanding an ARM

That 5/1 ARM rate is the highest it has been since February 2011. While still lower than a fixed-rate mortgage, the gap is closing and may not make the initial lower cost of an adjustable-rate mortgage worthwhile in a few years.

The initial interest rate of an ARM is only fixed for a set amount of time — five years for a 5/1 ARM that is adjusted once a year. After the initial term, the rate could go up or down, or remain the same. ARMS can also have an introductory rate lasting three, seven or 10 years.

An ARM can be used to purchase a home or refinance a loan on a home you already own.

The adjustment is based on a widely used interest rate index, with the one-year Libor the most commonly used benchmark, along with the weekly yield on the one-year Treasury bill.

An agreed-upon percentage point, called the margin, is added to the index to get the interest rate on the ARM when it’s adjusted. For example, an index at 1 percent and a margin of 2.75 percent would add up to an interest rate of 3.75 percent.

If the index climbs 5 percent in five years, that doesn’t necessarily mean you’ll be paying 7.75 percent interest when the ARM ends.

Caps, caps and more caps

ARMs usually come with caps on the annual adjustment and over the life of the loan. They vary among lenders, so it’s important to understand the terms of your loan. Here are three types of caps to be aware of with your ARM:

Initial adjustment cap: This sets how high the interest rate can go the first time when it adjusts after the fixed-rate period expires, such as five years. A common cap is 2 or 5 percent, meaning the new rate won’t be more than that many percentage points higher than the initial rate during the fixed-rate period.

Subsequent adjustment cap: Commonly set at 2 percent, this is how much the interest rate can increase in the adjustment periods that follow.

Lifetime adjustment cap: Often set at 5 percent, this term is how much the rate can increase in total over the life of the loan. The rate can never be more than this amount over the initial rate.

“Adjustable-rate mortgages can be very safe loans when properly understood,” says Anthony VanDyke, president of ALV Mortgage in Salt Lake City, Utah. “Homebuyers need to make sure they understand the adjustment terms and adjustment caps when it comes to ARMs.”

Borrowers should understand the highest their rate can go, and what that means for a monthly mortgage payment when refinancing their mortgage. This information should be included in a Truth in Lending disclosure given to you by your lender within three days of your loan application.

Even if you’re planning on moving within the initial rate period, it’s still smart to know how high the rate could adjust to in case circumstances change and you remain in the home.