5/1 ARM Loan: Everything You Need To Know

If you’re looking to buy a home, you might be overwhelmed with the sheer number of mortgage choices. In addition to varying loan types and terms, you’ll have to decide  whether you want a fixed-rate loan or an adjustable rate mortgage loan (ARM).

In this article, we’ll be discussing the 5/1 ARM, which is an adjustable-rate mortgage with an initial 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 type of adjustable rate mortgage loan (ARM) 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.

The words “variable” and “adjustable” are often used interchangeably. When people refer to variable-rate mortgages, they likely mean a mortgage with an adjustable rate. A true variable-rate mortgage has an interest rate that changes every month, but these aren’t common.

How Does A 5/1 ARM Work?

An ARM has a fixed rate for the first several years of the loan term that’s often called the initial 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, the 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 Secured Overnight Financing Rate (SOFR), 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.

What Should I Look For When Shopping For A 5/1 ARM?

When you’re comparing loan options, there are some special numbers 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 initial 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 this example, the 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 interest rates have moved lower.

5/1 ARM Loan Example

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 example, 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%.

On the fixed-rate mortgage, you’re looking at a monthly payment of $ 1,748 , not including taxes and insurance. This hypothetical ARM loan has an initial payment of $1,663. You save $85 per month for the first 5 years of the loan, but it’s important to remember this adjusts in the sixth year. If your ARM interest rate goes up by the maximum amount allowed under the cap, your new payment would be $ 2,011. In the seventh year, if interest rates were higher and it went up by the maximum amount, the new payment at a 11% interest rate would be $ $2,380 . Finally, if rates went way up, the lifetime cap on interest rate increases is 12%, so your new payment in the eighth year would be $2,571. It’s important to take these potential adjustments into account when you’re budgeting.

5/1 ARM Loan: Pros

All loan types come with pros and cons, and the 5/1 ARM is no exception. To better weigh these pros and cons, it helps to consider the differences between adjustable-rate and fixed-rate mortgages.

With that in mind, let’s start by looking at the relative pros of 5/1 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 $85 per month by going with an ARM. If we put that monthly savings on the principal, that’s $5,100 less on the balance at the end of the first 5 years. That means that instead of your payment being $2,011 when the interest rate resets at 9%, it would be $1,970 , 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 rate going up.