A 5-2-5 LIBOR home loan is an adjustable rate mortgage that you can use to purchase or refinance your home. Interest rates on adjustable loans move up and down with interest rates as a whole, and the lower the interest rate, the lower your payment. This means adjustable rate loans are appealing when rates in general are low. Variable rate loans become less attractive in rising rate environments. Fortunately, 5-2-5 loan contracts include caps that limit interest rate hikes during your loan term.
The London InterBank Offered Rate (LIBOR) is an index that reflects the average cost of short-term loans between banks that do business in the United Kingdom. It's basically the equivalent of the U.S. prime rate, as the cost of interbank lending has a direct impact on the cost of lending for the bank's customers. Some mortgage lenders use the one-year LIBOR rate as an index for adjustable-rate mortgages. Rates on these loans are reviewed at certain intervals. Adjustable mortgage rates go up or down in conjunction with changes in the LIBOR rate.
Normally, 5-2-5 LIBOR loans have 5/1 adjustable terms. This means you pay a fixed rate of interest for the first five years of the loan term, after which the interest rate changes once a year. The first "5" in the 5-2-5 equation refers to the interest-rate cap for the first reset. This means your rate can increase by a rise in the LIBOR rate or by 5 percent (whichever is higher). These loans also include a floor below which your rate can never fall, but floors vary between lenders and loan contracts.
After the initial interest rate reset, your rate may change on an annual basis. On a 5-2-5 loan the annual rate hike cannot exceed the higher of any increase in the LIBOR or 2 percent. As with the first rate reset, your contract may include a rate floor below which your rate can't fall. Rate caps are designed to reduce the risk of what lenders refer to as "payment shock." You experience payment shock if your rate and your payment suddenly rise and you find yourself unable to afford your mortgage. If you can't make your payment, your home may end up going into foreclosure. Even if you avoid foreclosure, late payments will hurt your credit score and make it harder for you to get new loans.
The last "5" in the 5-2-5 equation refers to the lifetime interest rate cap on a LIBOR loan. Interest rate hikes over the course of the loan term are capped at 5 percent. If your rate rose by 5 percent at the first rate reset, your lender can't increase that rate any more at the next rate reset. The annual 2 percent caps are meaningless if you rate jumps 5 percent at the first reset. More often than not, rates rise and fall over the course of a 30-year loan term. If rates fall far enough, the 2-percent annual cap may come back into play.