Buying a home and taking out a mortgage is always a big and exciting step – both personally and financially. And it’s easy to feel overwhelmed and confused about your mortgage options. You can choose a traditional, 30- or 15-year fixed mortgage, or you may want to look at your options for an adjustable-rate mortgage or a hybrid mortgage loan like a 5/1 ARM. Though adjustable-rate mortgages have gotten a bad rap in recent years, they do offer some benefits if you’re smart and plan effectively. We’ve outlined some of the significant pros and cons below – keep reading.
What is a 5/1 ARM?
In its most simple terms, a 5/1 ARM is a hybrid of an adjustable-rate mortgage and a fixed-rate mortgage. The loan starts at a fixed rate, which continues for the first five years. Then the rate becomes adjustable for the remainder of the loan’s term. The annual percentage rate will change once per year over the life of the loan, which also may cause your monthly payment to adjust.
The notation of the loan tells this story – the first number in the name of the loan is a five, which indicates how many years the loan will have a fixed interest rate. The second number is a one, which means the adjustment period, which is the time in between interest rate adjustments. In this case, the adjustment term is one year.
The Difference Between a 5/1 ARM and a Fixed-Rate Mortgage
Everyone has an essential choice when applying for a mortgage loan: a fixed-rate or an adjustable-rate loan. The difference is in how the interest rate is assigned and whether it’s allowed to change over the loan’s term. With a traditional, fixed-rate mortgage loan, you’re assigned an interest rate when the loan is awarded, and the rate remains the same over the full 15 or 30 years of the loan’s life. With an adjustable-rate mortgage, though, the rate you’re assigned at the award of the loan is typically much lower than rates assigned to a fixed-rate loan. Experts often call this a “teaser rate” since it lasts for an introductory period only. For a 5/1 ARM, which represents something of a hybrid of the two loan types, you keep that rate for the first five years of your loan.
After that, the interest rate changes once per year according to a predetermined index – which means it can adjust to be either higher or lower than your initial rate. So while you enjoy the benefit of a lower introductory interest rate, you run the risk of your interest rate rising higher than what you may have gotten with a fixed-rate mortgage loan. Since you have no control over where your interest rate will go in the coming years, it’s something of a gamble.
Which Type of Loan is More Popular?
By a hefty margin, the most popular mortgage loan product in the United States is the 30-year, fixed-rate mortgage loan. It’s easy, and it makes people feel safe. They know they’ll be charged precisely the same interest rate over the full term of the loan.
And the most popular adjustable-rate loan is the 5/1 ARM hybrid. It’s always going to come with a lower interest rate than a 30-year fixed mortgage loan. That’s the benefit you get for being willing to take the risk of how high the interest rate might rise over the remaining 25 years of the loan’s term. The differences in rates for the two types of loans historically have been as small as 0.27 percent and as large as 1.30 percent.
How Do the Two Different Loan Types Affect Borrowers?
Now let’s look at how the difference in loan term can play out for a particular borrower. First, let’s assume that a home buyer is taking on a $200,000 home mortgage. If the buyer chooses a 30-year, fixed-rate mortgage and scores an interest rate of 4.1 percent, that puts the monthly payment at $966.40, excluding taxes and insurance. At the end of five years, this home buyer will have paid roughly $7,407 in interest and $4,190 toward the actual principal.
On the other hand, the buyer who went with a 5/1 ARM – with an interest rate of 3.7 percent – starts with a monthly payment of $$920.57, excluding taxes and insurance. At the end of the introductory five-year term, she will have paid roughly $6,640 in interest and $4,407 toward the loan principal. So not only has this buyer saved on interest costs, but she’s also gained more equity in the home by paying down the principal faster.
However, things can start to change once the loan enters its adjustable-rate period. For example, let’s say that after two interest rate adjustments over two years, the percentage rate jumps to 4.95 percent. That will bump the monthly mortgage payment to $1,067.54, not including taxes and insurance. There’s no guarantee that the interest rate will jump this high, but it could. It could also go lower or stay the same – there’s no predicting it, so you have to be prepared for the highest possible bump.
5/1 ARM – Pros and Cons
Overall, adjustable-rate mortgage loans are popular with consumers since they allow you to get your mortgage at what usually is a very low interest rate. And hybrid ARMs may be especially popular because they allow consumers that first five years’ worth of stability before the interest rate begins to change. Most lenders offer some version of a hybrid ARM, and the 5/1 is one of the most common and sought-after combinations – you can also find hybrids in 3/1, 7/1, and 10/1 combinations.
While considering whether a 5/1 ARM is right for you, several key factors should weigh into your decision. We’ve broken down some of the significant pros and cons for you below.
5/1 ARM Pros
Depending on your situation, a 5/1 ARM can offer several benefits, which we explore below.
A Lower Starting Interest Rate
Your loan will start less expensively than a traditional, 30-year, fixed-rate mortgage. You’ll have a lower interest rate for the first five years of your loan, which allows you to build equity in your home more quickly. Because a 5/1 ARM is a hybrid mortgage loan, it will offer you a lower rate than a fixed-rate mortgage, while a slightly higher rate than a traditional adjustable-rate mortgage – at least at the beginning. The important thing to note: depending on index performance, a rising interest rate in the later life of the loan can effectively eat up any interest savings during the first five-year term of the mortgage.
A Lower Starting Monthly Payment
Because your interest rate is lower than with a fixed-rate mortgage, your monthly payment will be lower as well for the first five years of your loan. This makes an adjustable-rate mortgage extremely attractive to many home buyers. Depending on the size of your loan, a consumer with a good to excellent credit score can expect to save as much as $100 on a monthly mortgage payment by choosing a 5/1 ARM over a traditional fixed-rate mortgage loan. Especially if you have other high-interest debt or savings goals, this extra money in your pocket can go to great use. Or you can choose to invest those savings somewhere that gives you an even higher return.
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A Chance for an Even Lower Rate and Payment in the Future
Depending on the behavior of the market, your adjustable interest rate could drop even lower in the future. While we often caution about the risk of rising interest rates, we can’t forget that the reverse is also true. If the interest rate does drop while you have the loan, you’ll be looking at a lower monthly payment. On the flip side, if you go with a fixed-rate mortgage, you don’t feel any effects if interest rates drop – unless you refinance your loan, which comes with closing costs and additional fees. You also have to qualify in order to refinance your loan.
Quicker Equity in Your Home
Because the interest rate is lower, going for a 5/1 ARM can help you more quickly build equity in your home. This is especially true if you sign on for the adjustable-rate loan, yet pay as if it’s a 30-year, fixed-rate loan. If you go this route, by the end of the first five years, you’ll have made a considerable dent in your overall mortgage loan balance. In fact, you’ll have made a more significant dent than a borrower who went with a traditional fixed-rate mortgage, which raises your overall net worth.
And if you get used to paying that higher payment, you won’t feel a pinch if interest rates rise at the end of your five-year introductory period. At that point, your new payment will simply match what you’ve been paying already.
Many financial experts advise that signing a 30-year fixed-rate mortgage for a home you plan to live in for considerably less than 30 years is a fool’s game. It means you’ll pay thousands more in interest over the term of the loan, and when you sell it, you’ll own less of it than if you go with a 5/1 ARM or similarly structured adjustable-rate loan.
5/1 ARM Cons
In addition to its benefits, a 5/1 ARM also comes with several downsides that you should consider before committing to this type of mortgage. We explore a few below.
The Risk of Higher Future Interest
Once your initial five-year, fixed-rate mortgage period is over, your rate will adjust every year, based on an index tied to returns on investments such as U.S. Treasury securities, which typically adjust in relationship to overall world markets. The index could also be based on the Cost of Funds Index, the one-year constant maturity Treasury rate, or the London Interbank Offered Rate.
That means you have no control over where your interest rate may land from year to year. Your interest rate determines your monthly payment and potentially how quickly you’re able to pay your loan in full. Also, homeowners who stay in their homes for more than five years may pay more in interest over the life of the loan than they would with a traditional, fixed-rate mortgage. It’s all a gamble as to how the index will affect your overall interest rate from year to year. Your rate may go down in a given year, but it also may rise substantially. You should also know that lenders typically charge a margin on top of the index rate to cover their fees.
Also, a hybrid adjustable-rate mortgage like a 5/1 ARM will begin with a higher interest rate than a traditional adjustable-rate loan.
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The Risk of Higher Future Monthly Payment
If your interest rate goes up, so will your monthly payment, so you should look at your finances, do the math and make sure you can afford the monthly payments if they go up once you reach the end of your five-year, fixed-interest introductory period. Luckily, most 5/1 ARMs have a lifetime cap that will limit how much interest will ultimately be able to rise. Look at your worst-case scenario and ensure that you can make your monthly payment even if it meets the limit.
Also, many adjustable-rate loans have a yearly cap that limits how much your interest rate can rise year over year. For example, you might find an adjustable-rate loan with a 2 percent yearly cap and a lifetime 5 percent cap. Just make sure you research to make sure you fully understand how your interest rate can change after the five-year mark.
How Do I Know If a 5/1 ARM is Right For Me?
There are situations in which a 5/1 ARM may be of benefit to a home buyer. They offer the lower rates of an adjustable-rate mortgage, combined with some of the stability of a fixed-rate mortgage. We’ve outlined below some of the most common buyers who might benefit from a 5/1 ARM.
Short-Term Buyers
For example, if you believe you will move or sell your home before the five-year, fixed-rate term is over, the 5/1 ARM can be a good move. This allows you to take advantage of the stability the first five years can offer before the interest rate becomes adjustable while keeping your expenses as low as possible. Some experts advise that the 5/1 is especially useful for first-time buyers who don’t think they’ll be in their home very long.
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Buyers With Less-Than-Perfect Credit
If your credit isn’t great, a 5/1 ARM can also help you out. For example, if your FICO score is around 630, that’s high enough to qualify you for a 30-year fixed-rate mortgage. However, you’re not going to get the most competitive rates, which are saved for consumers with good to excellent credit. In this situation, choosing a 5/1 ARM allows you to keep your mortgage payment manageable while you work on raising your credit score. At the end of the five years, you then have the opportunity to refinance your loan with better credit and, presumably, a lower fixed rate.
Buyers Who Suspect Short-Term Interest Rate Increases
Even for a long-term home buyer who plans to stay put for the full 30 years, a 5/1 ARM can make sense if mortgage rates rise. They’re manageably low right now, but if they were to rise above 7 percent or more, it might make sense for a homeowner to take advantage of the 5/1 ARM’s introductory period to allow fixed interest rates to fall. Then they can refinance – as long as they’re prepared for closing costs and fees.
Buyers Who Plan to Quickly Pay Off Their Mortgage Loan
A 5/1 ARM may also be a good move for someone who plans to pay off their mortgage very quickly. If you’re able to pay the full loan amount before the end of the five-year introductory period, then you never have to worry about the rising interest rate. Think about it – if you know you’re going to pay off the loan quickly, why would you pay more interest to your lender than you have to?
Just make sure to understand the terms of your loan entirely. Some lenders and some states discourage this practice by charging penalties to anyone who pays off or refinances their loan before the end of the first five years. Just do your research to make sure you understand any penalties your lender might charge in this situation. Even if you plan to exit your loan before the five years is up, take note: make sure you can handle the adjustable payments in case market forces or personal circumstances force you to stay in your home longer than you originally planned.
If you plan to stay in your home for more than five years, you can also use the five-year intro period to stack up equity in your home by paying the extra principal. If you adjust from the beginning to the practice of paying more than the required monthly payment, you won’t feel squeezed if interest rates rise. Plus, you’ll have more equity in your home at the end of that first five years than someone with a fixed-rate mortgage.
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The Bottom Line
As with most personal finance decisions and financial products, the type of mortgage you choose is dependent on your specific financial circumstances, and your comfort with risk. First, do your homework, ask the right questions, and take a frank look at your financial resources. Then choose the best mortgage for you. Just as no two houses are alike, neither are two buyers – or their specific circumstances and temperaments.
If you’re smart about it, make a plan and stick to it, you can use a 5/1 ARM to your financial advantage. A savvy investor who has a healthy tolerance for risk can enjoy serious savings with this type of loan and potentially use those savings to invest somewhere else for a higher return.
Have you ever tried an adjustable-rate mortgage? Tell us about your experience below.
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