What Is a 5/5 ARM and Should I Get One?
Choosing an adjustable-rate mortgage (ARM) means that you’re able to enjoy a low, fixed interest rate for the first few years of your loan term, but you’ll eventually have a variable rate that changes over time. A 5/5 ARM may provide the best features of both worlds, but there are also risks that could make the loan unaffordable in the long run.
What is a 5/5 ARM?
A 5/5 ARM is an adjustable-rate mortgage that has a fixed mortgage rate for the first five years of a 30-year loan term. After that, the mortgage rate becomes variable and adjusts every five years.
The rate adjustments on 5/5 ARMs are tied to a benchmark interest rate called an index, such as the LIBOR or the 1-Year Constant Maturity Treasury Index. There’s also a margin, which is a set number of percentage points that a lender adds to the index to determine your mortgage rate. For example, if the index is 2.5% and the margin is 2%, your rate at that time would be 4.5%.
Like most adjustable-rate mortgages, 5/5 ARMs may have a lifetime rate adjustment maximum. Usually, rates can’t increase by more than five percentage points over the life of the loan, though the exact cap varies by lender. So, if you have a 5-year ARM with an initial 4.5% interest rate and a lifetime cap of 5%, the maximum interest rate your lender could ever charge you is 9.5%.
ARM loans also often come with adjustment caps that limit how much the interest rate can increase each time it adjusts. For example, a 5/5 ARM may have a 2% periodic adjustment cap, so if your existing rate is 4.5%, the rate can’t increase to more than 6.5% at the next five-year mark.
The benchmark interest rate could also decrease, in which case your mortgage rate would also drop. If interest rates fall, you’d lock in a lower rate for at least the next five years.
Comparing 5/5 ARM and 5/1 ARM loans
A 5/1 ARM is another type of adjustable-rate mortgage. Similar to the 5/5 ARM, the mortgage rate on a 5/1 ARM is fixed for the first five years of the loan. The rate then adjusts annually thereafter, which differs from the rate adjustments on a 5/5 ARM that happens once every five years.
Both 5/5 ARMs and 5/1 ARMs have 30-year payoff schedules and rate adjustment caps. However, the two loan types have some key differences, including their initial interest rates. Let’s look at an example, using LendingTree’s home loan calculator. The assumptions here are a $200,000 loan with a 30-year repayment term.
|5/1 ARM||5/5 ARM|
|Initital interest rate||3.10%||2.5%|
|Monthly payment (principal and interest)||$854.03||$790.24|
As of this writing, the typical 5/1 ARM rate was about 3.10%, according to Freddie Mac’s Primary Mortgage Market Survey. A quick online search of mortgage lenders offering 5/5 ARMs had rates around or slightly below 2.5%. This 60-percentage-point difference in rates could save you more than $60 on your monthly mortgage payment during the first five years of your loan.
Pros and cons of 5/5 ARMs
- Lower initial rates compared to a 30-year fixed loan. In many cases, homebuyers may find that mortgage rates are initially lower on 5/5 ARMs than on 30-year fixed-rate mortgages. Depending on how long you stay in the house, starting out with a lower rate could also mean you pay less in interest costs over the life of the loan, even if rates move up.
- More time between rate adjustments. Unlike the 5/1 ARM loan, the 5/5 ARM gives you more time to prepare for an interest rate and monthly payment increase. You have five years to decide whether a potential 2% jump in your rate is affordable. If it’s not, you have the option to refinance your ARM into a fixed-rate loan or sell your home.
- More borrowing power. Having a lower initial interest rate means your monthly payments start out lower. This also means you may qualify for a slightly larger loan amount without needing more income.
- Lower monthly payments are possible. You can’t predict the movement of interest rates. But if rates drop overall by the time you’re due for your next adjustment, your mortgage rate will also decrease. A lower interest rate translates to a lower monthly payment for the next five years.
- Fewer lending options. 5/5 ARMs are a niche loan product, so you may have to put in more effort to find mortgage lenders who offer them. Start by checking with local banks and credit unions.
- Prepayment penalty fees are possible. Some adjustable-rate mortgages may carry prepayment penalties if you pay off the loan within the first three to five years, according to the Federal Reserve Board. Lenders must disclose prepayment penalties on your loan estimate, so keep this in mind if you think you’ll move in less than five years or plan to refinance.
- No conversion options. Most 5/5 ARMs don’t offer a fixed-rate option. That means borrowers who are worried about rising interest rates will instead have to apply and qualify for a mortgage refinance, which can cost 2% to 6% of the new loan amount.
- Higher monthly payments are possible. Fixed-rate mortgages offer the security of a stable payment over the life of a loan, while ARM loans offer no such guarantee. If your mortgage rate jumps by two full percentage points when it adjusts, your monthly payments could increase by a few hundred dollars.
How to decide between a fixed-rate and adjustable-rate loan
The 5/5 ARM is something of a hybrid between a fixed-rate and adjustable-rate mortgage with periodic increases. You get the benefit of a significantly lower rate and monthly payment amount during your first five years — provided your credit history qualifies you for a competitive interest rate. Plus, you have a full five years to prepare for each potential payment increase.
The 5/5 ARM can be ideal for homebuyers who:
- Want to quickly pay down their mortgage
- Expect substantial increases in their income over time
- Plan to sell their home within a few years
On the other hand, people with incomes that don’t fluctuate much or those who plan to stay in their home long term may prefer the security of a fixed-rate mortgage.