For younger people just getting established, a 5/1 adjustable-rate mortgage, or ARM, can be the key to home ownership. These loans carry a relatively low interest rate for the first five years, making payments more affordable. After that, they adjust to a (usually higher) market-based rate. A 5/1 ARM might be right if you don't intend to stay in the house long-term, if you plan to refinance your mortgage, if you expect your income to rise substantially or if you're not worried about interest rates rising.
An adjustable-rate mortgage differs from a traditional home loan, which has a fixed interest rate. If you take out a fixed-rate mortgage at 6 percent interest, then that's the rate you'll pay for the length of the loan; interest rates can rise or fall, but you'll be locked in at 6 percent. An adjustable-rate mortgage, by contrast, has a rate that adjusts. If the interest-rate index that your mortgage rate is pegged to declines, then so will your mortgage rate -- and so will your monthly mortgage payment. But if interest rates rise, then your monthly payment will rise, too.
Adjustable-rate mortgages typically start with a low, fixed rate that lasts for a specified term before the adjustments begin. The "5" in the 5/1 ARM means that the low initial rate is good for five years. At the end of those five years, the rate "resets" to a market-based interest rate. That's when the roller-coaster ride can start. The "1" in the 5/1 ARM means that the rate may adjust every year. Because of the fixed-rate period at the beginning, these mortgages are sometimes called "hybrid ARMs."
Adjustable-rate mortgages typically come with rate caps that limit how much your interest rate can rise in a year or over the life of the loan. That way, if you're paying a 3 percent initial rate and the market-based rate is 9 percent when it comes time to adjust, you don't have to swallow the whole increase at once. An ARM might come with, say, a limit of 2 percentage points a year and a total increase capped at 5.5 points. In that case, the rate would rise to 5 percent the first year -- the maximum 2-point increase. Assuming market rates stayed at 9 percent, your rate would rise to 7 percent the next year and 8.5 percent the next year. It wouldn't go to 9 percent, though, because your total increase is limited to 5.5 points. Caps apply on the way down, too, so if market rates fell back down to 4 percent, your rate would come down only 2 points per year.
Getting Out Early
By now you may have identified how to dodge the rising-rate bullet in the 5/1 ARM. If you can refinance the loan before the five-year fixed rate expires, you never have to face a potentially costly adjustment. For that reason, some lenders impose prepayment penalties on ARM loans, which swat you in the pocketbook for refinancing. Plus, if market interest rates have risen substantially, your rate is going to go up even if you do refinance. Refinancing to a fixed-rate mortgage would protect you from further increases, though.