Five-year adjustable rate mortgages are often desirable for their low initial rates. The loan combines a five-year starter period during which the interest rate is fixed with a 25-year period of adjustable interest based on the prevailing prime rate. Understanding how to calculate a five-year ARM mortgage can help you evaluate whether this is a good option for your financing needs.

## Interest Rates

The interest rate on a five-year adjustable rate mortgage begins as a fixed rate. The rate is typically lower than a fixed-rate mortgage of the same length. During the initial five years, the rate can't change and your payments are set in stone. Once the five-year period has passed, the rate is subject to change according to the current prime rate and the lender's margin of increase. The margin percentage per year is determined by the lender and agreed to in the contract. In the years that follow the first five-year period, the lender has the power to adjust the interest rate once per year at its discretion.

## Potential Savings

The potential for savings with an adjustable rate mortgage start with the initial five-year period when your rate is low and set in place. Because you are taking a risk on the interest of the loan in the future, lenders offer an incentive to get you to sign on. Further savings can come once the loan becomes adjustable if the prime rate has fallen from where it was when you started and continues to do so for the life of the loan. In this case, the amount you can save is also limited by a hard minimum interest cap as set in your contract.

## Calculating Your Monthly Payment

To find out how much your monthly ARM mortgage payment will be, you must employ the industry standard formula to your loan specifics. The formula requires that you add 1 plus the interest rate of your loan written as a decimal. Factor the sum by the negative product of the term of the loan in months multiplied by the number of months it is to be amortized. Subtract the result from 1, then invert it. Multiply the result by the monthly interest of your loan written as a decimal, then multiply the product by the total principal of the loan. The result is your monthly mortgage payment according to the initial interest rate. In the case of a 5 percent rate and $100,000 loan, the payment amount will be about $536 per month.

## Amortization

To calculate amortization for your ARM loan, divide the mortgage interest rate by 12 so it can be assessed on a monthly basis. If you have a 5 percent loan this will work out to .4166. Multiply .4166 by the balance due on the loan which in this case will be $100,000 to get $416.66. This is the amount of interest due for the first month's payment on your loan. Now subtract the interest amount from the total monthly payment as calculated in step 3. This remaining number is the amount of your payment that will go toward the loan principal. Because the principal will be reduced slightly by the first month's payment, the next month's calculations will be different with a bit more of your payment going toward principal than interest. Things will continue this way until the loan has been paid in full, with exceptions for changes in interest rate once the initial period has ended.

## Preparing for Changes

Once your initial fixed rate interest period has ended, your loan payments will vary based on what rate is current. The amount that your lender can raise or lower the interest rate is capped by a maximum according to your individual contract. For example, if your loan is capped by a 1 percent rise or fall in interest rates per year, the payment can only go up or down by that much. With a 5 percent initial rate, your sixth-year payments can only go up to 6 percent, or fall to 4 percent. Of course in the years to come, this pattern can continue until the maximum or minimum interest cap is reached as outlined in your particular contract.

## Calculating Your Payments

With the first 60 payments out of the way, you will need to create a system for calculating the remaining 300 (based on a 30-year term). Add 1 percent to the interest rate per year starting in the sixth year and working until you have reached the high-end cap. While most increases will be lower than 1 percent, if they come at all, this will allow you to determine the highest possible payment.

## Early Payoff

If you plan to sell the property within the first five years of the loan, or just after that, the benefits of the loan are even greater. You get to lock in the low initial rate and avoid any rise in rates in the years to come. If the rates on your ARM become too much to handle later in the term, you may also be able to refinance if your contract allows. In cases of sale or refinancing, some lenders may charge early termination fees. These fees are designed to recoup some of the money you would have paid to the lender in interest had the loan gone to term.

References

- Quicken Loans: Adjustable Rate Mortgage
- Lending Tree: 5 Year ARM
- The Federal Reserve Board: Consumer Handbook on Adjustable-Rate Mortgages
- Bank Rate: Mortgage Calculator
- CNN Money: Don't Get Trapped in an ARM
- Lending Tree: Adjustable Rate Mortgage Calculator
- Mortgage Professor: Mortgage Formulas
- Mortgage Professor: Mortgage Amortization: How Does it Work?

Writer Bio

Robert Morello has an extensive travel, marketing and business background. He graduated with a Bachelor of Arts from Columbia University in 2002 and has worked in travel as a guide, corporate senior marketing and product manager and travel consultant/expert. Morello is a professional writer and adjunct professor of travel and tourism.