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5/1 ARM Rates: Understanding the Pros and Cons

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If you’re looking to get a lower monthly mortgage payment and don’t plan to stay in your home long, a 5/1 adjustable-rate mortgage (ARM) may be worth considering. With rates typically lower than a 30-year fixed mortgage for the first five years, 5/1 ARM rates give you a path to homeownership while freeing up room in your monthly budget.

A 5/1 ARM isn’t without risk, though. After the introductory fixed-rate period ends, your loan’s interest rate resets and your payment could become unaffordable.

What is a 5/1 ARM?

A 5/1 ARM is a type of adjustable-rate mortgage (ARM) with a fixed rate for the first five years. After that period, 5/1 ARM rates can go up or down based on the terms of your loan.

During the initial fixed-rate period, the rate is typically lower. After that, the rate can change based on five factors:

  • The initial adjustment cap. Once the fixed-rate expires, the initial adjustment cap limits how much the interest rate can rise. The typical initial adjustment caps are generally 2% or 5%.
  • The adjustment period. Changes to an ARM mortgage rate are based on the adjustment period. For example, a 5/1 ARM will adjust every year after the five-year teaser rate period ends. Lenders may offer adjustment periods ranging from every month to every five years.
  • The margin. A margin is a fixed number set by the lender and added to the index to determine your rate when it adjusts.
  • The index. An index is a benchmark variable rate, like the constant-maturity Treasury or the Cost of Funds Index (COFI). These indices fluctuate based on market and economic conditions. The margin is added to your index to determine your rate with each adjustment period, and lenders should provide information to show how the chosen index has changed over time.
  • The lifetime cap. Many ARMs have a 5% lifetime cap, which means your rate can’t go up more than 5% from where it started.
MORTGAGE TIP:

When you’re getting a 5/1 ARM rate quote, make sure you understand all of the potential adjustments.

5/1 ARM rate payment example

Below is an example of how much your payment could increase on a 5/1 ARM with 2/2/5 caps, an initial fixed rate of 3% and a $250,000 loan amount.

ARM Adjustment period Rate Monthly Payment
Initial 5-year fixed rate 3% $1,054.01
First-year adjustment cap 2% above the start rate 5% $1,299.34
Lifetime cap 5% above the start rate 8% $1,698.44

 

If you don’t refinance to a fixed-rate before your ARM resets, you could pay an extra $245.33 per month on your mortgage payment with the first adjustment. In the worst case scenario, the monthly payment would jump by $644.43.

How do fixed rates compare to adjustable-rate mortgage rates?

Most homeowners prefer the stability of a low 30-year fixed-rate mortgage payment for the life of their loan. However, there are situations when the lower payment of a 5/1 ARM rate makes sense — for example, if you’re planning to relocate within five years, and want to stash the savings from a 5-year ARM payment into a moving expense account.

Below is a side-by-side look at the features of a fixed-rate mortgage vs a 5/1 ARM.

Features of a 5/1 ARM Features of a fixed-rate mortgage
Payment is typically lower than fixed rate first five years Payment is higher than 5/1 ARM during the fixed-rate period
Variable-rate that could increase after the teaser period expires Rate is fixed for life of the loan
Available for conventional, *FHA and **VA financing Available for conventional, *FHA and **VA financing

*FHA loans are insured by the Federal Housing Administration and offer easy qualifying guidelines
**VA loans are guaranteed by the U.S. Department of Veterans Affairs and offered to eligible active-duty and veteran military service members and their spouses.

Pros and cons of a 5/1 ARM

Is a 5/1 ARM a good idea? You may find 5/1 ARM rates today are easier on your wallet at first, but there are longer-term risks. Understanding the advantages and disadvantages of a 5/1 ARM will help you make the most informed decision.

Pros

  • You’ll get a lower rate and monthly payment for the first five years of your loan.
  • Your payment could fall if rates drop after the initial fixed-rate period ends.
  • You can use extra monthly payment savings to stockpile savings.
  • You can apply the monthly savings to the principal to pay your loan balance down faster.
  • You could opt for an interest-only payment to save extra money each month.

Cons

  • Your adjustable interest rate could rise after the 5-year fixed period.
  • Your payments might fluctuate for the remainder of the loan term.
  • You may have a hard time selling your home if you had planned to move before the ARM resets and home values drop.
  • You won’t be required to pay principal for a set time period (usually three to 10 years)  with 5-year, interest-only rates. However, that could result in a large payment increase when the interest-only period ends.

Is a 5/1 ARM loan right for you?

If you have time-specific financial goals, a 5/1 ARM mortgage may help accomplish them.

Consider a 5-year ARM if you:
  • Plan to sell or refinance before the adjustable-rate period expires. It may be hard to time a sale exactly with a pending ARM adjustment. Give yourself plenty of lead time to market your home or budget for the first payment adjustment.
  • Know your income will go up. If a raise or bonus is in your future, you don’t have to worry as much about payment increases.
  • Make more than the minimum down payment. A lower loan amount equals a lower payment. That may soften the impact if you can’t pay an ARM mortgage off before it adjusts.
  • Can afford the fully indexed payment. In the example above, there’s a $600 plus bump in payment if you end up in an ARM longer than expected. Avoid choosing an ARM if the higher payment would strain your budget.
  • Know the adjustments of the ARM plan you’ve selected. There’s a big difference between how much your rate will go up on a 5-year ARM with 2/2/5 caps and 5/2/5 caps. Review the consumer handbook on adjustable-rate mortgages, along with the ARM adjustments on each loan estimate, so you know the worst-case payment scenarios.
  • Shop around for your best rate. Some mortgage lenders specialize in ARMs, while others focus their best pricing on 30-year, fixed-rate mortgages. Try a comparison rate site to gather mortgage quotes from three to five different lenders to find your best 5/1 ARM mortgage rates.
 

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