Buying a new home is exciting, but it can also be confusing. Once fairly simple, mortgages today come in all shapes and sizes, and your lender may throw a lot of options at you. One of the options you may hear about is the 5/1 ARM. The 5/1 ARM's meaning is that your loan will have a fixed interest rate for the first five years and an adjustable rate that can change every year after that. Like all mortgages, this one has pros and cons to consider before signing on the dotted line.
With a 5/1 ARM mortgage, your interest rate remains fixed for the first five years of the loan. After that, the interest rate adjusts once a year.
5/1 ARM Mortgage Definition
There are essentially two main types of mortgages. The first is the fixed-rate mortgage. With a fixed rate mortgage, your lender determines the interest rate based on your credit score and current market conditions. This interest rate remains in effect for the life of your loan. The other common mortgage type is the adjustable-rate mortgage, or ARM. The adjustable-rate mortgage's definition is a mortgage with an interest rate that may change from time to time throughout the life of the loan. With an ARM, the interest rate you pay on the mortgage can go up or down over the life of the loan. Your interest rate will adjust along with changing market conditions. The amount of your monthly mortgage payment will also change, going up or down along with your interest rate.
A 5/1 ARM mortgage is a hybrid mortgage that combines fixed and adjustable mortgages into one loan. In a 5/1 ARM, the five indicates the number of years your interest rate will remain fixed. In this case, the interest rate won't change during the first five years of the mortgage. The one represents how often the interest rate can change once your five-year fixed period is up. A one means that your interest rate can only change once a year.
Some lenders also offer 3/1, 7/1 and 10/1 ARMs. These mortgages work in the same way, offering three, seven or 10 years at a fixed interest rate before switching to an adjustable rate. You may even see a 5/6 ARM. In that case, the interest rate remains fixed for five years and then adjusts every six months.
How Adjustments Work
When your lender does adjust your interest rate, they don't do so arbitrarily. First, the two of you will agree on your margin rate. The margin rate is the amount of interest you will pay over and above the market index. Your lender, for example, may set a margin rate of 2.75 percent. This means that when your interest rate adjusts, it will become the index rate plus the specified margin rate.
The index rate is an interest rate determined by a neutral third party. Several different agencies maintain indexes. The popular London Interbank Offered Rate is an index maintained by the ICE Benchmark Administration. This index monitors the strength of five different currencies and sets its rates accordingly. Other popular indexes include the Constant Maturity Treasury, the 11th District Cost of Funds Index and the Moving Treasury Average. Some of these indexes track averages, while others simply take a snapshot of the current market conditions.
If the index your lender uses is at 1.25 percent and your margin rate is 2.75 percent, your new adjusted interest rate is 4 percent (1.25 index rate plus 2.75 margin rate). Your lender will check the index they use and perform this calculation every time your mortgage rate adjusts.
5/1 ARM Benefits
The 5/1 ARM mortgage design offers some benefits that can really help savvy investors. If you're a house flipper or plan to sell the home in five years or less, a 5/1 ARM can provide a great introductory interest rate. It won't matter if the rate goes up after five years since you will have sold the house long before.
A 5/1 ARM can also make it easier to get into your first home. If money is a little tight, but buying a home is on your to-do list, a 5/1 mortgage arrangement lets you get your foot in the door sooner rather than later. You can spend five years building equity in your own home rather than spending the same amount of time throwing money away on a rental. Your mortgage interest rate may go up in five years, but by then you'll hopefully have a better job or will have paid off some other debts so you can afford it.
The 5/1 plan also works well for those who like to gamble a bit. Yes, the interest rate on the mortgage could go up at the end of five years, but it could also go down. If interest rates are favorable and have been for some time, you may find that your interest rate and monthly payment both go down in five years. During periods of low interest, you can save some money or make additional principal payments to pay off your mortgage quicker.
5/1 ARM Pitfalls
A 5/1 ARM can work quite well if things go according to your plans. Life doesn't always work that way, though. Opt for this arrangement only if you're sure you can sell the house. Refinance it or make higher mortgage payments if necessary. Most 5/1 ARM mortgages include a cap that limits how high your interest rate can go. Make sure yours does and that you can handle the payments at that rate just in case you need to. If the housing market takes a nose dive during your fixed interest rate period, you could find yourself upside down and unable to sell the home or make the new mortgage payment when it adjusts.
It's also important to make sure that your loan doesn't include a penalty for early payment. Some do, and the fees can be substantial. If you do succeed at selling the home and paying the mortgage off early, your lender's fee can take a big bite out of your profits or the down payment on your next home. Read your mortgage documents carefully to ensure you won't face a penalty for doing well.
Some Other Options
While some borrowers feel more comfortable with a fixed-rate mortgage, no one wants to lock in a high interest rate for 30 years. Some instead opt for a 5/1 ARM mortgage, hoping that their interest rate will go down when it adjusts. This is a viable option, but you do run the risk of interest rates climbing rather than dropping as hoped.
If an increase in your interest rate at the five-year mark would financially cripple you, consider a fixed-rate 15-year mortgage. These shorter mortgages typically come with the same interest rate at which 5/1 ARMs start. With a fixed mortgage, however, you won't have to worry about the interest rate going up. Since you pay a lower interest rate when you pay the loan in half the time, your mortgage payments won't double when you go from a 30-year to a 15-year mortgage. In 2018, for example, a monthly Freddie Mac mortgage payment of $1,467 for a 30-year mortgage increases to only $2,120 with a 15-year loan. If you can handle the higher payment, you can lock in a better interest rate and not worry about the possibility of it rising.