Is a 5-1 ARM the Best Option for Your Home Loan?

An open note book lying next to a calculator. One page says “fixed rate” and the other page says “adjustable rate”Are you considering a 5-1 ARM for your home loan but not sure if it's the best option for you? In this article, we will explore the benefits and drawbacks of a 5-1 ARM, and help you determine if it's the right choice for your financial situation. Let's delve into the world of adjustable-rate mortgages and see if a 5-1 ARM could be the perfect fit for your home financing needs.

Key Takeaways on 5-1 ARM Loans

The significant points to understand about 5-1 adjustable-rate mortgages are:

  • The initial rate is fixed for five years and then can be adjusted annually based on the market index.
  • 5-1 ARMs offer lower starting rates but present payment shock risks later.
  • Check the annual and lifetime rate caps, which limit increases.
  • Run the numbers to see if ARM interest savings outweigh refinancing to a fixed rate later.
  • Compare your situation to when ARMs or fixed rates may be preferable based on your budget, plans, and rate outlook.

What Is a 5-1 Adjustable-Rate Mortgage (ARM)?

A 5-1 adjustable-rate mortgage keeps your interest rate fixed for the first five years of the loan. After that, the speed can be adjusted annually based on market conditions for the remaining loan term.

Here are some key features of a 5-1 ARM:

  • Initial fixed rate for five years, then adjusts annually
  • Lower introductory rate than fixed mortgages
  • Rate tied to an index like U.S. Treasury securities
  • Lifetime and annual rate caps limit increases.
  • 30-year loan term

While the interest rate adjusts, the loan payment (principal plus interest) stays fixed for the entire 30-year term.

5-1 ARMs offer lower initial rates to help you qualify for more homes, but they carry the risk of payment shock once the momentum starts adjusting higher.

How Do ARM Rate Adjustments Work?

With a 5-1 ARM, the interest rate adjustment process happens like this each year once the initial 5-year fixed period ends:

  1. The lender looks at the currently used index rate, often based on U.S. Treasury securities.
  2. A 2.5–3% margin is added to the index rate to determine your new rate for the next 12 months.
  3. Specific rate caps provide some protection.
  4. The annual cap limits increase to typically 1-2% per year.
  5. The lifetime cap prevents the rate from exceeding a set maximum, often 5% above the start rate.

Under this structure, an ARM rate adjustment is limited yearly and over the loan's lifetime. Just know that payments can still rise significantly over time as rates increase.

Pros of a 5-1 Adjustable-Rate Mortgage

Some potential benefits of 5-1 ARM loans include:

  • Lower initial interest rate: The introductory fixed rate is typically 0.5–1% less than comparable fixed mortgages. This leads to lower initial monthly mortgage payments.
  • Qualify for more: The lower rate may allow you to qualify for a more significant loan than a fixed-rate mortgage.
  • Delay higher rates: This Gives you five years before rate adjustments start if rates increase over time.
  • Lower lifetime interest costs: If you sell or refinance within 5-7 years, an ARM results in less total interest paid than a fixed loan.
  • Potential payment savings: If rates fall in the future, your payment could adjust downward after the initial fixed period.

For homebuyers looking for lower initial costs and payments while accepting some interest rate risk in the future, a 5-1 ARM can be a good option under the right circumstances.

Cons of a 5-1 Adjustable-Rate Mortgage

The disadvantages of ARMs that homeowners need to be aware of are:

  • Payment shock risk: If rates rise substantially, your payment can spike significantly after year five. Difficult to budget.
  • Harder to qualify for refinancing: If rates go up a lot, you may no longer qualify for a favorable fixed-rate refinance.
  • ARM vs. fixed breakeven point: It takes around seven years before the total interest savings of an ARM outweigh closing costs to refinance into a fixed rate.
  • Variable housing cost: Your mortgage payment may adjust up or down annually, making it harder to predict expenses.
  • The lifetime rate cap provides limited protection; hitting the lifetime cap may still mean unaffordable payment increases.

While 5-1 ARMs offer lower initial rates, the interest rate risk they carry must be carefully considered.

Who Should Consider a 5-1 ARM?

Specific borrower profiles and homeownership situations may be well-suited for a 5-1 adjustable-rate mortgage:

  • Plan to move within 5-7 years. The lower initial ARM rate saves on interest costs if you sell before rate adjustments begin.
  • Qualify for more homes initially. The intro rate allows you to stretch your budget to purchase a higher-priced property.
  • Income expected to rise: Future earnings increases over time help offset higher mortgage payments as rates adjust.
  • Can handle payment adjustments. Financially able to adapt if rates, and in turn monthly payments, go up substantially after year 5.
  • Want lower initial costs? You Need to minimize expenses at the home purchase time but accept higher lifetime interest costs.

ARMs can provide significant short-term savings. But make sure you evaluate and prepare for the longer-term risks.

When Do Fixed-Rate Mortgages Make More Sense?

Here are some situations where a fixed-rate mortgage may be the wiser choice compared to a 5-1 ARM:

  • Holding the home long term: If not selling for 10+ years, fixed rates ensure predictable, stable payments for the entire time.
  • Rates are low currently. Today's fixed rates of around 6% are still relatively low historically, and locking them in provides peace of mind.
  • Minimize payment shock risk: The certainty of fixed payments is preferable if you are on a tight budget or entering retirement soon.
  • Strong preference for stability: You highly value knowing your mortgage expense will remain unchanged over decades.
  • Plan significant home improvements. An ARM could make sense if you are not upgrading since you may move before the rate spikes.

Unless you expect to move quickly, current low fixed rates provide long-term stability compared to the risk of variable ARM rates over decades.

ARM vs. Fixed: Impact on Monthly Payments

Let's compare the potential mortgage payment impacts of an ARM vs. a fixed-rate loan:

Initial payments: 5-1 ARM rates are around 0.625% lower currently, initially saving roughly $125 monthly on a $300,000 balance.

ARM payment adjustments: After year 5, a 1-2% annual rate increase could raise payments by around $100–200 per year on that balance.

Fixed-rate consistency: A 30-year fixed payment remains the same through the full 30-year term, regardless of rate changes.

Refinancing a fixed rate: If rates fall in the future, you'd have to refinance to lower a fixed-rate payment, taking on closing costs.

Lifetime interest costs: ARMs cost less interest if sold in 5-7 years. Long-term, fixed rates produce more significant interest savings.

Evaluate whether the ARM interest rate risk outweighs the fixed rate stability and long-term savings. Your time horizon at home is critical.

How to Decide: ARM or Fixed Mortgage Rate?

Determining if an adjustable-rate mortgage or fixed-rate loan makes the most financial sense depends largely on your situation.

  • Consider if you can handle payment increases or prefer payment certainty.
  • Look at total ARM costs if rates rise over time and how much payments could increase.
  • Determine the breakeven point where ARM savings are no longer more advantageous than closing costs to eventually refinance into a fixed rate.
  • Project your timeline for staying in the home and whether you'll move before the potential rate spikes.
  • Compare interest rates for 5-1 ARM loans to current fixed mortgage rates and determine the initial savings.
  • Review your budget to see if you qualify for the monthly payments at the highest potential ARM interest rate.

Doing a breakeven analysis and "stress testing" your budget will help determine if a 5-1 ARM or fixed-rate mortgage aligns better with your home financing needs and goals.

Refinancing an ARM Into a Fixed-Rate Loan

If initial discounted rates were attractive, but ARM rates rose to unaffordable levels later on, you may want to refinance into a fixed-rate mortgage. This allows you to lock in a stable payment for the remainder of your term.

But running the numbers in advance is critical to see if refinancing an ARM makes sense for your situation if rates spike. Just like with any mortgage, you'll need to qualify for a new fixed loan and cover closing costs to refinance out of your adjustable ARM.

Adjustable Rate Mortgage (ARM): Flexibility with Some Risk

Adjustable-rate mortgages (ARM) offer flexibility but come with some risk. At the beginning of the loan, you typically enjoy a lower interest rate, often referred to as the rate for the first five years. This initial rate can be significantly lower than you'd find with a fixed-rate mortgage, allowing for lower monthly payments.

However, after the initial period, often five years, the interest rate can adjust based on market conditions. This is known as the rate resets. The adjustment frequency varies but typically occurs annually, and the speed can change every year after that.

ARMs are structured around a specific index, like the Cost of Funds Index (COFI) or the Secured Overnight Financing Rate (SOFR), plus a margin determined by your lender. When the index rises, your interest rate and monthly payments can also increase, which means you could end up with higher prices over time.

While ARMs can provide a lower interest rate for the first few years of the loan, it's essential to carefully consider your financial situation and your tolerance for potential rate increases before choosing this option. Mortgage lenders often offer a range of loan types, so it's crucial to thoroughly evaluate your loan options and choose one that aligns with your long-term financial goals.

Conclusion: Is a 5-1 ARM the Best Option for Your Home Loan?

In conclusion, a 5-1 ARM can be a viable option for homebuyers seeking flexibility in their mortgage terms. While it offers lower initial interest rates and potential savings in the short term, there are risks associated with potential rate increases after the initial fixed period.

It is important to carefully consider your financial goals and tolerance for risk before committing to a 5-1 ARM. Consulting with a mortgage advisor can provide valuable insights and guidance in making an informed decision about your home loan options. Take the time to evaluate all factors involved and make the choice that aligns best with your long-term financial objectives.

Consumer Handbook on Adjustable-rate Mortgages

Recommended Reading

Frequently Asked Questions about Conventional Loans
How Do Conventional Loan Points Work?
Conventional Loan Interest Rates: Today's Market Rates
How Much Down Payment for a Conventional Loan?