5/1 ARM Loan: Everything You Need To Know
Kevin Graham8-minute read
August 06, 2021
Mortgage lenders offer a variety of options when it comes to the type of financing you can get to buy or refinance a home. In addition to varying loan types and terms, you can choose whether you want a fixed-rate loan or an adjustable rate mortgage loan (ARM). A third type of mortgage you might run across is a variable-rate mortgage, but in practice, these aren’t offered by very many lenders, if any, because of lending regulations. The words “variable” and “adjustable” are often used interchangeably, so nowadays, when people refer to variable-rate mortgages, they likely mean a mortgage with an adjustable rate.
In this article, we’ll be discussing the 5/1 ARM, which is an adjustable rate mortgage with a rate that’s initially fixed at a rate lower than comparable fixed-rate mortgages for the first 5 years of your loan term.
What Is A 5/1 ARM Loan?
A 5/1 ARM is a mortgage loan with a fixed interest rate for the first 5 years. Afterward, the 5/1 ARM switches to an adjustable interest rate for the remainder of its term.
An ARM has a fixed rate for the first several years of the loan term that’s often called the teaser rate because it’s lower than any comparable rate you can get for a fixed-rate mortgage. Rates may be fixed for 7 or 10 years, although the 5-year ARM is a very common option.
Once the fixed-rate portion of the term is over, and ARM adjusts up or down based on current market rates, subject to caps governing how much the rate can go up in any particular adjustment. Typically, the adjustment happens once per year.
When the rate adjusts, the new rate is calculated by adding an index number to a margin specified in your mortgage documentation. Common indexes used to figure out rates for ARMs include the Cost of Funds Index (COFI) and the Constant Maturity Treasuries (CMT).
Each time your interest rate changes, your payment is recalculated so that your loan is paid off by the end of your term. Terms on ARMs are usually 30 years, but they don’t have to be.
When you’re comparing loan options, there are some special members to pay attention to when looking specifically at ARMs. For example, you may see one advertised as a 5/1 ARM with 2/2/5 caps. Let’s break down what that means, one number at a time.
- Fixed or teaser rate period: The first number specifies how long the rate stays fixed at the beginning of the term, in this case 5 years.
- Adjustment intervals: The next number tells you how often the rate adjusts once the fixed-rate portion of the loan is over. For example, a 5/1 ARM adjusts once per year.
- Initial cap: The first cap is a limit on the amount the rate can adjust upward the first time the payment adjusts. In this case, regardless of market conditions, the first adjustment can’t be an increase of higher than 2%.
- Caps on subsequent adjustments: In our example above, with each adjustment after the first one, the rate can’t go up more than 2%.
- Lifetime cap: The final number is the lifetime limit on increases. Regardless of market conditions, this mortgage interest rate can’t go up more than 5% for as long as you have the loan.
Other than the margin in your loan documentation, there’s no limiting factor to how much your interest rate could adjust down in any particular year if an interest rates have moved lower.
To really get a feel for an ARM, let’s do an example comparing it with a fixed-rate mortgage for a $250,000 loan amount. In our hypothetical example, let’s say you can get a 30-year fixed-rate mortgage at 4%. We’ll compare that against a 5/1 ARM with 2/2/5 caps and an initial interest rate of 3.5%.
On the fixed-rate mortgage, you’re looking at a monthly payment of $1,193.54, not including taxes and insurance. Our ARM has an initial payment of $1,122.61. You save $70.93 per month for the first 5 years of the loan, but it’s important to remember this adjusts in year 6. If it goes up by the maximum amount allowed under the cap, your new payment would be $1,377.05. In the 7th year, if interest rates were quite a bit a higher and it went up by the maximum amount, the new payment at a 7.5% interest rate would be $1,648.71. Finally, if rates went way up, the lifetime cap on interest rate increases is 5%, so your new payment in year 8 would be $1,788.81. It’s important to take these potential adjustments into account when you’re budgeting.
When getting yourself into an ARM, one thing that can be helpful is to understand the relationship between principal and interest and how it changes over time as you get into your mortgage term. At the beginning of your term, almost all of your mortgage payment will go toward paying interest. As the years go by, this flips so that by the end of the term, the vast majority of the payment is toward the principal. But you can also put extra money toward the principal every month if you aren’t subject to any prepayment penalties your lender might charge. Rocket Mortgage® doesn’t have these. We’ll get into the benefits of paying down principal in a second, but adopting this strategy could be helpful for those who plan ahead.
5/1 ARM Loan Pros And Cons
Adjustable rate mortgages have their benefits, but they’re not right for everyone. Although there is a fixed-rate portion of the loan that may make it more attractive than a truly variable-rate mortgage, it’s important to realize that the potential for future upward adjustment means that there is less certainty than you would get with a fixed-rate mortgage. In understanding the differences between adjustable rate and fixed-rate mortgages, it helps to take a look at the pros and cons of ARMs.
Let’s start with the benefits of ARMs.
- Lower initial interest rate: Because the interest rate can change in the future, an ARM is structured so that you can get a lower interest rate for the first several years of the loan than you would if you were to go with a comparable fixed rate. This lower payment can give you financial flexibility to buy things you need for the house, invest or put it back directly toward the principal.
- Potential to pay less overall interest: One way to save money over the life of the loan when you get an ARM is to put the money you save from that lower interest rate back directly toward the principal. In this way, even if the interest rate adjusts upward, you’re paying less in interest because you’re paying it on a lower balance. To see how this works in practice, let’s take a look at the earlier scenario where we were saving $70.93 per month by going with an ARM. If we put that monthly savings on the principal, that’s $4,255.80 less on the balance at the end of the first 5 years. That means that instead of your payment being $1,377.05 when the interest rate resets at 5.5%, it would be $1,350.91, not to mention the interest savings over the lifetime of the loan.
- Could be good for short-timers: If you know that you’re in a starter home and will be moving in a few years, you might move before the interest rate ever adjusts. This requires some planning and forecasting of your future, but if it works out, you may not have to deal with the rest of the rate going up.
As we mentioned above, ARMs do have their downsides. Let’s run through them.
- Potential for a higher mortgage payment long-term: Because the teaser rate on ARMs is lower than the prevailing market rate on fixed-rate mortgages, your long-term payment will often be higher.
- You’ll likely pay more interest over time: Because the interest rate will often go up, you’re going to have a higher chance of paying more interest over time.
- Refinancing to a fixed rate will come with fees: It’s true that you can refinance into a fixed-rate mortgage when it comes time for your rate adjustment. However, you should be aware that there are closing costs associated with any refinance either in the form of upfront fees or paid off over time by taking a higher interest rate. Closing costs can be anywhere between 3% – 6% of the loan amount, although they tend to be lower on a refinance.
- Rate difference isn’t always worth it: As interest rates go down, there tends to be a narrowing of the yield curve. This gets a little bit technical, but basically the yield curve deals with the difference between fixed- and adjustable rate mortgages. If you’re saving a significant amount on the front end of the loan by going with an ARM, it can be worth it. If the difference is 10 basis points (10 hundredths of a percentage point), not so much.
Is A 5/1 ARM Loan Right For You?
Assuming market conditions with a decent spread between fixed and adjustable rates, 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 financial flexibility. In addition, as we saw earlier, you can pay down quite a bit of principal by taking the payment savings in the initial years and putting it back toward the balance.
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.
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A Final Word
A 5/1 ARM is a mortgage with a fixed rate for the first 5 years of the loan, after which it adjusts up or down once per year based on the movement of a market-driven index, subject to caps on increases. These can be best for people who only plan to be in their property a short time because they’ll move before the rate adjusts. It’s also good if you plan to take the savings on the payment and pay down interest. On the downside, how much you save on the front side is tied heavily to market conditions, so that’s something to be aware of.
Additionally, you don’t have the payment certainty that comes with a fixed-rate mortgage. For this reason, whether the property is a starter home or a forever home can play a big role in whether an ARM is right for you. If you’re ready to move forward with your mortgage process, you can apply online with Rocket Mortgage®.
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