5 1 Arm Loan What Is It
Our goal is to give you the tools and confidence you need to improve your finances. Although we receive compensation from our partner lenders, whom we will always identify, all opinions are our own. Credible Operations, Inc. NMLS # 1681276, is referred to here as "Credible."
One of the ways to save on interest, at least at the beginning of your mortgage, is to get a 5/1 adjustable rate mortgage (5/1 ARM). With a 5/1 ARM, you have a fixed rate for the first five years of your mortgage, with the rate adjusting every year after that.
A 5/1 ARM can help you get a lower interest rate initially, which can make it attractive to certain homebuyers.
Here's what you need to know about 5/1 ARM loans:
- What is a 5/1 ARM loan?
- How a 5/1 ARM works
- Pros and cons of a 5/1 ARM
- When to consider a 5/1 ARM
What is a 5/1 ARM loan?
When you get a mortgage, you often choose between a fixed-rate and an adjustable rate loan. An adjustable rate mortgage, or ARM, is a home loan where the interest rate has the potential to change over time.
A 5/1 ARM is a type of hybrid mortgage that includes a fixed rate for a set period of time before switching to an adjustable rate.
Here's what the two numbers indicate:
- The first number: The number of years in which your interest rate remains fixed.
- The second number: How often the rate will adjust annually after that fixed period.
For example, if you had a 5/1 ARM with a 30-year term, you'd have a fixed interest rate for the first five years. After that, you'd see your rate and payment change once a year for the remaining 25 years.
Good to know: The 5/1 ARM is one the most popular types of adjustable rate mortgage loans, and most lenders offer at least one type of ARM loan.
Learn More: What Is a Mortgage Rate and How Do They Work?
How a 5/1 ARM works
A 5/1 ARM loan works by starting with a fixed interest rate and switching to an adjustable interest rate later. Your rate is fixed for five years, and then every year after that, the rate will move higher or lower, depending on market rates.
There are usually caps on how high the interest rate can adjust. Each time your rate adjusts, your payment will adjust as well, to ensure that you pay off your mortgage on time.
Here's a closer look at how 5/1 ARMs work:
Changing rates
Your adjustable interest rate is based on a specific index and margin. Each year, your lender will look at the index specified in your paperwork and add the required margin to it — this will be your new rate for the coming year.
Here's a quick breakdown of what the index and margin are and how they work:
- Index: The benchmark interest rate based on current market conditions. In the past, many mortgages used the London Interbank Offered Rate (LIBOR), but that's being phased out in favor of the Secured Overnight Financing Rate (SOFR). Other indexes that might be considered include the Cost of Funds Index (COFI) and Constant Maturity Treasuries (CMT).
- Margin: This is the fixed amount that's added to the index by your lender, giving you your interest rate for the year. For example, if you have a margin of 3% and your rate adjusts based on the SOFR — and the SOFR is at 0.15% — your new mortgage rate would be 3.15%.
Tip: Ask your lender to find out what index it uses, along with the margin it adds to the index.
Interest rate caps
The good news is that your mortgage interest adjustment is limited. So, you won't see your rate shoot up out of nowhere.
In many cases, a lender will issue a cap based on the first adjustment, subsequent adjustments, and a lifetime cap. A common cap is the 2/2/5 cap. Here's how this cap structure works:
- Initial adjustment cap: The first number represents the initial adjustment cap. This is the first time the lender changes the rate after the fixed rate ends. So, in this case, the rate can't be more than two percentage points higher than your initial rate, no matter how much interest rates have increased.
- Subsequent adjustment cap: The second number reflects the cap on following adjustments. Once again, in this case, the adjustment can't go higher than two percentage points.
- Lifetime cap: The final number shows the lifetime cap. As long as you have the loan, the interest rate can't go five percentage points beyond your initial rate if you have a 2/2/5 cap.
Learn More: 3/1 ARM: Your Guide to 3-Year Adjustable-Rate Mortgages
Loan terms
5/1 ARMs typically come with an overall term of 15 years or 30 years. The interest rate remains fixed for the first five years and then adjusts every year after that for the remainder of the loan.
To see what your monthly payment would be at a certain interest rate, use the calculator below.
Enter your loan information to calculate how much you could pay
? Enter the total amount borrowed $
? Enter your annual interest rate %
or
? Enter the amount of time you have to repay your loan years
With a $ home loan, you will pay $ monthly and a total of $ in interest over the life of your loan. You will pay a total of $ over the life of the mortgage.
Need a home loan?
Credible makes getting a mortgage easy. It only takes 3 minutes to see if you qualify for an instant streamlined pre-approval letter.
Find Rates Now
Checking rates won't affect your credit score.
To get a better idea of what you'd pay each month (in principal and interest only) with a 5/1 ARM vs. a fixed-rate mortgage, let's run through a quick example.
Example: Say you're looking to take out a $250,000 mortgage, and you have to choose between a 30-year fixed-rate loan at 3.75% APR and a 5/1 ARM with an initial APR of 2.50%.
- With the fixed-rate loan, your monthly payment would be $1,158 and you'd end up paying $166,804 in interest over the life of the loan.
- With the 5/1 ARM, your monthly payment for the first five years would be about $987. Assuming your loan follows the 2/2/5 cap structure, the highest amount you'd end up paying each month after the initial period would work out to approximately $1,581. Depending on the adjustments, you could end up paying over $268,000 in interest.
Pros and cons of a 5/1 ARM
The low initial interest rate of an adjustable-rate mortgage makes it an enticing option, and it could make homebuying more affordable for you.
But you'll have to be comfortable with the uncertainty. If rates rise, you might get saddled with a higher mortgage payment and have to pay more interest in the long run.
Pros
- Lower initial interest rate: With a lower interest rate to start, you'll get to enjoy a lower mortgage payment during the first few years of your loan. Knowing this, you can use the difference to invest, pay down principal, or make improvements to the house.
- Might end up paying less in interest: As long as rates stay low, you might be able to save on interest. On top of that, if you take the difference in payment amount versus a fixed-rate loan and apply it toward the principal, you reduce the balance that you pay interest on.
- Can be beneficial if you know you'll move soon: If you know you're going to move within five years, before the rate adjusts, you could save. When you know you're not staying in the home, you can make appropriate adjustments and save on monthly cash flow and interest.
Cons
- Potentially higher mortgage payment: If rates rise, so will your mortgage payment. After the initial period, you could see increasing payments, up to the cap. If that's the case, it could cause problems for your monthly budget.
- Could pay more in interest over the loan term: If rates trend higher, over time you could end up paying more in interest overall — even with a rate cap.
- Rate difference might not be worth the trouble: If there isn't a big difference in the interest rate of a fixed-rate loan and an ARM, the slightly higher initial payment with a fixed-rate loan might be the better choice. Especially since refinancing your mortgage can add more costs should you decide to switch to a fixed-rate loan down the road.
Credible can be a huge help when trying to find a great interest rate. You can easily compare our partner lenders and see prequalified rates in as little as three minutes — all without leaving our platform.
Credible makes getting a mortgage easy
- Instant streamlined pre-approval: It only takes 3 minutes to see if you qualify for an instant streamlined pre-approval letter, without affecting your credit.
- We keep your data private: Compare rates from multiple lenders without your data being sold or getting spammed.
- A modern approach to mortgages: Complete your mortgage online with bank integrations and automatic updates. Talk to a loan officer only if you want to.
Find Rates Now
When to consider a 5/1 ARM
Opting for a 5/1 ARM makes sense if you don't plan on living in your home for the long-term. If you intend to sell the home within five years, you can take advantage of the ARM's lower initial fixed interest rate and lower initial monthly payment.
If you'll be in the home for five years or more, an ARM is riskier. Since the rate can fluctuate, you might end up with a higher interest rate and minimum monthly payment.
If you decide to refinance before the end of the fixed term, realize that you might have to pay refinancing closing costs that could negate the savings from the lower interest and payments.
About the author
Miranda Marquit
Miranda Marquit is a mortgage, investing, and business authority. Her work has appeared on NPR, Marketwatch, FOX Business, The Hill, U.S. News & World Report, Forbes, and more.
Read More
Source: https://www.credible.com/blog/mortgages/5-1-arm/