A 5/1 ARM — whose interest rate is fixed for the first five years and then adjusts once a year — can be a good choice for a short-term homeowner.
While most borrowers will opt for a conventional 30-year fixed-rate mortgage, some buyers are drawn to the low teaser rate of an ARM.
Here’s a closer look at adjustable-rate mortgages and the 5/1 ARM in particular.
Adjustable-Rate Mortgages, Defined
An adjustable-rate mortgage typically has a lower initial interest rate — often for three to 10 years — than a comparable fixed-rate mortgage.
Then the rate “resets” up (or down) based on current market rates, with caps dictating how much the rate can change in any adjustment.
With most ARMs, the rate adjusts once a year after the initial fixed-rate period.
Recommended: Fixed Rate vs. Adjustable Rate Mortgages: Key Differences to Know
What Is a 5/1 ARM?
Adjustable-rate mortgages come in the form of a 3/1, 7/1, 10/1, 10/6 (the rate adjusts every six months after 10 years), and more, but the most common is the 5/1 ARM.
With a 5/1 ARM, the interest rate is fixed for the first five years of the loan, and then the rate will adjust once a year — hence the “1.” Adjustments are based on current market rates for the remainder of the loan.
Because borrowers may see their rate rise, they need to be sure they can afford the larger payments if they don’t plan to sell their house, pay off the loan, or refinance the loan.
How 5/1 ARM Rates Work
An ARM interest rate is made up of the index and the margin. The index is a measure of interest rates in general. The margin is an extra amount the lender adds, and is constant over the life of the loan.
Caps on how high (or low) your rate can go will affect your payments.
Let’s say you’re shopping for a 5/1 ARM and you see one with 3/2/5 caps. Here’s how the 3/2/5 breaks down:
• Initial cap. Limits the amount the interest rate can adjust up or down the first time the payment adjusts. In this case, after five years, the rate can adjust by up to three percentage points. If your ARM carries a 4.5% initial rate and market rates have risen, it could go up to 7.5%.
• Cap on subsequent adjustments. In the example, the rate can’t go up or down more than two percentage points with each adjustment after the first one.
• Lifetime cap. The rate can never go up more than five percentage points in the lifetime of the loan.
When Does a 5/1 ARM Adjust?
The rate will adjust annually after five years.
Pros and Cons of 5/1 ARMs
Borrowers should be aware of all the upsides and downsides if they feel a call to ARMs.
Pros of a 5/1 ARM
A lower interest rate up front. The initial five-year rate is usually lower than that of a fixed-rate mortgage. This can be an advantage for new homeowners who lack the cash needed to furnish the home and pay for landscaping and maintenance. And first-time homebuyers may gravitate toward an ARM because lower rates increase their buying power.
Could be a good fit for short-term homeowners. Some buyers may only need a home for five years or less: those who plan to downsize or upsize, business professionals who think they might be transferred, and the like. These borrowers may get the best of both worlds with a 5/1 ARM: a low interest rate and no risk of higher rates later on, as they’ll likely sell the home and move before the rate adjustment period kicks in.
A 5/1 ARM borrower may be able to save significantly more cash over the first five years of the loan than they would with a conventional home loan.
Modern ARMs are less dicey. The risky ARMs available before the financial crisis that let borrowers pay just the interest on the loan or choose their own payment amount are no longer widely available.
Potential for long-term benefit. If interest rates dip or remain steady, an ARM could be less expensive over a long period than a fixed-rate mortgage.
First-time homebuyers can
prequalify for a SoFi mortgage loan,
with as little as 3% down.
Cons of a 5/1 ARM
Risk of higher long-term interest rates. The good fortune with a 5/1 ARM runs out after five years, with the likelihood of higher interest rates. Rising inflation affects mortgage rates indirectly. The loan could reset to a rate leading to mortgage payments the borrower finds uncomfortable or downright unaffordable.
Higher overall home loan costs. If interest rates rise with a 5/1 ARM, homeowners will pay more over the entire loan than they would have with a fixed-rate mortgage.
Refinancing fees. You can refinance an ARM to a fixed-rate loan, but expect to pay closing costs of 2% to 6% of the loan. A no closing cost refinance offers no real escape: The borrower either adds the closing costs to the principal or accepts an increased interest rate.
Possible negative amortization. Payment caps limit the amount of payment increases, so payments may not cover all the interest due on your loan. The unpaid interest is added to your debt, and interest may be charged on that amount. You might owe the lender more later in the loan term than you did at the start. Be sure you know whether the ARM you are considering can have negative amortization, the Federal Reserve advises.
Possible prepayment penalty. Prepayment penalties are rare now, but check for any penalty if you were to refinance or pay off the ARM within the first three to five years.
Comparing Adjustable-Rate Mortgages
When you take out a mortgage, you choose a mortgage term. Most fixed-rate mortgage loans, and ARMs, are 30-year loans.
5/1 ARM vs 10/1 ARM
A five-year ARM has a five-year low fixed rate followed by 25 years with an adjustable rate. A 10-year ARM offers 10 years at a fixed rate, then 20 years of adjustments.
In general, the shorter the fixed-rate period, the lower the introductory rate.
5/1 vs 7/1 ARM
Same song, different verse. The 7/1 ARM has a seven-year fixed rate instead of five for the 5/1 ARM. The initial interest rate on the 7/1 probably will be a little higher than the 5/1.
Is a 5/1 ARM Right for You?
Is a 5/1 ARM loan a good idea? It depends on your finances and goals.
In general, adjustable-rate mortgages make sense when there’s a sizable interest rate gap between ARMs and fixed-rate mortgages. If you can get a great deal on a fixed-rate mortgage, an ARM may not be as attractive.
If you plan on being in the home for a long time, then one fixed, reliable interest rate for the life of the loan may be the smarter move.
An ARM presents a trade-off: You get a lower initial rate in exchange for assuming risk over the long run.
Your best bet on ARMs? Tips from the Fed:
• Talk to a trusted financial advisor or housing counselor.
• Get information in writing about each ARM program of interest before you have paid a nonrefundable fee.
• Ask your mortgage broker or lender about anything you don’t understand, such as index rates, margins, and caps. Ask about any prepayment penalty.
• If you apply for a loan, you will get more information, including the mortgage APR and a payment schedule. The annual percentage rate takes into account interest, any fees paid to the lender, mortgage points, and any mortgage insurance premiums. You can compare APRs and terms for similar ARMs.
• It’s a good idea to shop around and negotiate for the best deal.
The Takeaway
A 5/1 ARM offers borrowers a low initial rate but risk over the long run. Tempted by a sweet introductory rate? It’s a good idea to know how long you plan to stay in the home and to be clear about rate adjustments.
If one low fixed rate from here to eternity — well, up to 30 years — sounds good, check out SoFi Mortgages. SoFi offers fixed-rate home loans, mortgages for second homes and investment properties, and refinancing.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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