5/1 ARM loan: Everything you need to know

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When shopping for a mortgage, you’ll come across many options designed to fit the needs of different types of buyers. If you’ve found a property you like but don’t plan on keeping it long-term, an adjustable-rate mortgage like a 5/1 ARM might be worth a look. Unlike more traditional fixed-rate loans, an ARM has an initial period with a set interest rate that adjusts at specific intervals outlined in the agreement with your lender. This may mean lower payments for buyers who plan to sell their home within a few years.

In this guide we’ll explore what 5/1 ARMs are and how they work, so you can decide if this kind of mortgage aligns with your home purchasing timeline and financial goals.

How does a 5/1 ARM work?

An adjustable-rate mortgage is a mortgage with an interest rate that is set for an initial period and then changes on a regular basis after that. Generally speaking, the first number that appears before an ARM is the number of years that the loan is fixed, and the second number is the number of times the mortgage rate will adjust per year after the initial fixed-rate period. In the case of a 5/1 ARM, the rate is set for the first five years, then adjusts once per year after that. That means your principal and interest payment won’t change for the first five years. Usually, ARMs have thirty-year repayment terms.

Typically, rates for ARMs are initially lower than interest rates for fixed-rate loans. That can make them more affordable during the initial rate lock. After the rate lock ends, the rate and monthly payment can rise or fall, so you need to plan ahead when choosing an ARM.

What should I know when considering a 5/1 ARM?

If you’re considering a 5/1 ARM, it’s important to understand the different terms and concepts that apply to them. For example, you might hear these loans advertised with even more numbers or jargon, such as a 5/1 ARM with a 2/2/5 cap. We’ll cover the key concepts here.

Interest rate changes

Once the initial interest rate period ends, your loan’s interest rate will start to change. Depending on the terms of your loan and the interest rate market, the rate could rise or fall. That means your monthly payment could go up or down. If it rises, your mortgage payment will increase, and your loan can become harder to afford.

Most ARMs use an index rate and a margin to determine the new rate at each adjustment. For example, the rate may be the constant maturity rate + 2% or the secured overnight funding rate + 2.5%. In some cases, the amount your rate can rise or fall in one adjustment, as well as how far it can rise or fall in total, will be limited by a rate cap or floor.

Adjustment intervals

The adjustment interval of an ARM is how frequently the loan’s rate can change. In the case of a 5/1 ARM, it changes after the initial five years elapse and goes on to change one time per year for as long as you have the loan.

At each adjustment interval, the rate could rise or fall depending on the rate cap and rate floor as well as the market rate. You should check your loan’s paperwork to understand how or if the rate can rise or fall, and so you can prepare for potentially varying mortgage payments.

Rate caps

Many ARMs come with rate caps. These place limits on how much your loan’s rate can change at one time, as well as a maximum limit on how high or low the rate can be.

For example, a 5/1 ARM with a 2/2/5 cap structure has a rate that can change no more than 2% at the initial and each subsequent adjustment period, with a maximum increase of 5% over the initial rate.

• Initial adjustment cap: This limits the amount the rate can adjust upward the first time the payment adjusts. In this example, regardless of market conditions, the first adjustment can’t exceed 2%.
• Periodic adjustment cap: Based on our example, with each adjustment after the first one, the rate can’t go up by more than 2%.
• Lifetime cap: The final number is the lifetime limit on increases. Regardless of market conditions, the mortgage’s interest rate can’t go up by more than 5% for as long as you have the loan.

Your loan’s estimate and closing disclosure should outline any rate caps that apply to your loan.

Interest rate floors

Like an interest rate cap, an interest rate floor sets a limit on how much your loan’s interest rate can change. In this case, it restricts how far the rate can fall rather than how high it can rise.

For example, if you have an ARM with a rate of 6% and a floor of 5%, even if the market rates would dictate that your loan’s rate should adjust to 4.5%, it will fall only to 5%.

5/1 ARM loan example

To really get a feel for an ARM, consider this example comparing it with a $250,000 fixed-rate mortgage.

Let’s say you can get a 30-year fixed-rate mortgage at 7.5%. We’ll compare that against a 5/1 ARM with 2/2/5 caps and an initial interest rate of 7%.

In our example with a fixed-rate mortgage, you’re looking at a monthly payment of $1,748, not including taxes and insurance. The ARM loan has an initial payment of $1,663, saving you $85 per month for the first 5 years of the loan.

After five years, the ARM’s rate changes while the fixed-rate mortgage stays the same.

If your ARM interest rate goes up by the maximum amount allowed under the cap, your new payment would be $ 2,012, nearly $300 a month more than the fixed-rate loan. In the seventh year, if interest rates were higher and went up by the maximum amount, the new payment at an 11% interest rate would be $2,381.

This illustration shows the importance of preparing for rising payments.

Pros of a 5/1 ARM

There are many benefits to getting a 5/1 ARM, including:

• Typically lower initial rate than for fixed-rate mortgages. You pay less in the initial years than with a fixed-rate mortgage.
• Caps on future rate hikes. There are some limits on how high your mortgage rate and payment can rise.
• Flexibility for short-term owners. If you refinance or sell before the initial rate period ends, you can save money overall on the loan.

Cons of a 5/1 ARM

5/1 ARMs, and other types of ARMs like 7/6 ARMs, aren’t right for everyone, so keep these drawbacks in mind.

• Potentially higher payments after the initial term. If rates rise, your monthly payment will increase too.
• Potentially higher interest cost. If rates rise, you could pay more in interest overall than with a fixed-rate loan.
• More complexity. ARMs may have more conditions, fees, and jargon involved than fixed-rate loans, so it can be harder to understand how they work or compare them to other loans. Be sure to ask your lender or a mortgage professional about any terms you don’t understand.
• Less predictability. Unpredictable payments mean you need to be prepared for the unexpected and able to handle possible increases in your payments.
• Less ideal for long-term owners. The unpredictability of your loan costs in the long run makes ARMs a worse choice for people buying their forever homes as opposed to a starter home. If you end up staying in your home and need to refinance to get a better mortgage term¹, you’ll have to pay closing costs again, which are usually 3% - 6% of the loan amount.

Is a 5/1 ARM loan right for you?

If you can find an ARM with a significantly lower rate than what’s available on fixed-rate mortgages, it can make sense to get an adjustable-rate mortgage, particularly if you know you plan to be out of the house by the time the rate would adjust.

This is because the upfront interest rates can be lower than anything you would get for a fixed rate under normal circumstances.

If market conditions change and there’s more of a difference between adjustable rates and fixed-rate mortgages, the lower rate on an ARM can help provide you with financial flexibility.

If you plan on being in your house for a long time, it’s probably best to take a look at a fixed-rate mortgage. This will provide you with long-term payment certainty.

You can use Rocket Mortgage’s loan calculator to get a better idea of the cost of different loans to help you decide if a 5/1 ARM is worth it.

FAQ

Before applying for an ARM, make sure you understand how they work.

How do I qualify for a 5/1 ARM?

Qualifying for an ARM is like qualifying for any other loan. Once you apply, the lender will check your credit, debt-to-income ratio, and other financial factors.

Why are 5/1 ARMs referred to as hybrids?

They’re referred to as hybrids because they behave like fixed-rate mortgages during the introductory period. For 5 years, home buyers who choose an ARM enjoy fixed payments, generally at a lower interest rate than buyers with a fixed-rate mortgage. It’s only after the introductory period ends that ARMs may become more expensive and unpredictable, depending on what is happening with interest rates in the macroeconomic environment.

What is a convertible 5/1 ARM?

Homeowners with a convertible 5/1 ARM have the option of converting their ARM into a fixed-rate mortgage at a time designated in the mortgage contract. Homeowners enjoy a low introductory rate as well as the peace of mind that comes with having a fixed-rate option. Keep in mind that Rocket Mortgage does not currently offer convertible ARMs.

What is a 5/1 interest-only ARM?

An interest-only loan is a type of nonconforming mortgage that charges only interest for a set introductory period. For example, if you choose a 5/1 interest-only ARM, you’ll make interest payments only for the first 5 years. Thereafter, your mortgage would start amortizing, meaning you would begin paying principal and interest as part of your monthly mortgage payment.

Rocket Mortgage does not currently offer interest-only loans.

What do I do if interest rates increase dramatically?

If interest rates rise by a large amount, there are a few things you can do.

One option is to plan for making payments based on your mortgage interest rate cap. Another option is to consider refinancing to a new fixed-rate loan if you think rates might rise further and you want to lock in a rate you can handle.

The bottom line: A 5/1 ARM can save you money under the right circumstances

ARMs let you trade predictability for affordability. For the first five years, a 5/1 ARM will typically have a lower interest rate and payment than a fixed-rate loan. However, after five years, the rate can adjust, potentially rising and making your mortgage payment more expensive. For people who only plan to keep a home for a few years, an ARM can be a good way to save money.

Before applying for any type of loan, make sure you consider all of your options and work with a lender to ensure you understand the ins and outs of how the loan will work. Once you feel ready, you can start an application with Rocket Mortgage ² today.

¹ Refinancing may increase finance charges over the life of the loan.

² Rocket Mortgage is a trademark of Rocket Mortgage, LLC or its affiliates.