A Guide To The 5/1 ARM Loan: What It Is And How It Works
When you buy a home, you have a choice between the type of mortgage you can get. For example, you might want to get a fixed-rate mortgage (where the interest rate doesn't change throughout the life of the loan) or an adjustable-rate loan (where the interest rate does change periodically).
A 5/1 adjustable-rate mortgage (5/1 ARM or 5 1 ARM) is an example of an adjustable-rate loan. In a 5/1 ARM, the rate is initially fixed at a rate lower than a comparable fixed-rate mortgage for the first 5 years of your loan.
An adjustable rate might offer some distinct advantages, which we'll go over in this article. No matter what type of mortgage you choose, it's important to find the right fit for your needs.
What’s A 5/1 ARM Loan?
A 5/1 ARM is an adjustable-rate mortgage (ARM). For the first 5 years of the loan term, the interest rate is fixed. After this initial fixed-rate period, the 5-year ARM assumes an adjustable interest rate for the remaining life of the loan. The "5" indicates the introductory rate, sometimes called the "teaser rate" and the "1" indicates the number of years thereafter it adjusts.
The 5/1 ARM isn't the only type of adjustable-rate mortgage. Some mortgages have a longer teaser rate and some offer a shorter teaser rate. The amount the ARM adjusts up and down depends on the index, or the benchmark index rate, that reflects general market conditions. Put simply, the index helps determine the interest rate.
Your 5/1 ARM rates also depend on the margin in your loan agreement as well as caps. Caps limit how your interest rate can change and are usually subject to an initial adjustment cap, a subsequent adjustment cap and a lifetime adjustment cap. We'll go over the details of adjustment periods and caps later on in the article.
How Does A 5/1 ARM Work?
How exactly does a 5/1 ARM work? Let's break down how this type of home loan operates.
The first number in the adjustable-rate mortgage corresponds with the duration of the loan’s fixed-rate interest rate period, the "5" in 5/1. A 7/1 ARM and a 10/1 ARM both offer longer teaser rates. In both of these, the fixed-rate periods are 7 and 10, respectively. Some types of ARMs offer a shorter teaser rate, such as a 3/1 ARM.
Unlike a fixed-rate mortgage, the fixed-rate period in an ARM only stays fixed for the number of years indicated in its name. In a fixed-rate mortgage, your interest rate and payment stays the same throughout the life of the loan.
After the fixed-rate period concludes, the second number in the ARM advertises how often the rate adjusts during the adjustment period – the "1" in a 5/1 ARM. Let's take a look at the structure of a couple of other adjustable-rate mortgages:
- 5/6 ARM: In a 5/6 ARM, the fixed-interest rate period is 5 years and the adjustment interval is 6 months, which means that the interest would adjust every 6 months.
- 5/2 ARM: In a 5/2 ARM, the "5" indicates a fixed-rate period of 5 years and the adjustment interval is 2 years, which means that the interest rate would adjust every 2 years.
You can figure out the adjustment interval of just about any ARM using these guidelines.
How Are 5/1 ARM Rates Determined?
The index and margin determine the adjustable interest rates on a 5/1 ARM.
An ARM index is a base interest rate used to calculate the adjustable interest rate on a 5/1 ARM loan. The ARM adjusts depending on market rates and is indicated based on common indexes such as the Constant Maturity Treasuries (CMT) securities, the Cost of Funds Index (COFI) and the Secured Overnight Financing Rate (SOFR).
Margin refers to a number of percentage points you'll pay, added to the index. It's calculated like this:
Index + Margin = Your Interest Rate
Your loan agreement will indicate your margin rate. Lenders use either a flat percentage or your credit score to determine your margin rate. The better your credit score, the lower your margin rate can be, though your rate will never be below the margin.
Here's how a mortgage lender adds percentage points – or margin – to an index rate:
Let's say a lender offers a margin of 2% and an index of 4% on a 30-year ARM. In this case, the fully indexed rate is 6%.
What Else Should I Know When Considering A 5/1 ARM?
Sometimes ARMs are advertised with additional numbers that communicate the different caps on the adjustable rates. For example, a 5/1 ARM may give you 2/2/6 loan caps, in which the first "2" refers to an initial rate cap, the second "2" refers to a periodic rate cap and the "6" refers to a lifetime cap.
Let's also take a look at another type of ARM with different caps. This particular type of ARM that adjusts once per year with those caps would be advertised as a 5/1 ARM with 2/2/5 caps.
The initial cap limits the amount the rate can adjust the first time. In other words, the adjustment cannot go over the initial cap. In the example listed above (2/2/6), the first "2" means that your initial cap cannot go up more than 2% the first time the payment adjusts.
The periodic cap, sometimes referred to as a cap on subsequent adjustments, indicates how much a subsequent adjustment can go up. In a periodic cap, each adjustment cannot go over the limit indicated. In the 2/2/6 example, the periodic cap cannot go up more than 2%.
The lifetime cap – or ceiling – refers to the lifetime limit on increases. The lifetime cap on a 2/2/6 ARM cannot go up more than 6%. In other words, the interest rate can never go over that limit.
Can I See An Example Of A 5/1 ARM Loan?
So, what's the difference between an ARM and a fixed-rate mortgage? Let's take a quick look at a 5/1 ARM with 2/2/6 to learn more about fluctuating monthly mortgage payments compared to a 30-year fixed-rate mortgage.
Let's say you plan to purchase a $75,000 home with a 5% fixed interest rate with $20,000 down. You'll pay $1,368.90 per month throughout the life of your home loan.
On the other hand, if you got a 5/1 ARM at a 4.25% introductory rate, your ARM payment would remain fixed for 60 months at $1,254.45. With a 6% cap on your ARM, your payment would go no higher than $2,064.92.
In this scenario, the ARM saves you money upfront, but can end up costing much more over the life of the loan.
What Are The Advantages And Disadvantages Of 5/1 ARMs?
Before you jump into a 5/1 ARM loan, you may wonder about the pros and cons of opting for this mortgage type. Let's take a look before you make a final decision as a borrower.
The benefits of a 5/1 ARM include the following:
- You’ll likely enjoy a low introductory rate. Initial mortgage rates are usually lower than rates on a fixed-rate mortgage.
- You might get lower interest rates overall. Mortgage rates may drop before an adjustment. This means that you may pay less over a good portion of the life of the loan. It may never increase up to that lifetime cap.
- You could potentially have lower monthly payments. You can start paying off principal with the money saved during the fixed-rate period. Putting the money toward principal could mean that you pay less in interest because you'll have a lower balance from putting your money toward interest.
- You could refinance your ARM home loan to a fixed-rate mortgage. You could decide later (especially in a scenario where your interest rates might trend upward later on) to refinance an ARM to a fixed-rate mortgage.
- You could sell before the adjustment period. You may also consider selling before the adjustment period. If you plan on moving into a starter home – or know for sure that you'll be moving in a few years – you may benefit from financing with an ARM. However, it's important to have a good idea of whether you might actually plan to move, which isn't always easy to get a sense of ahead of time.
What are the drawbacks of a 5/1 ARM? Let's take a look at why homebuyers may want to avoid a 5/1 ARM altogether:
- You may make a higher mortgage payment over the life of their loan. ARMs generally have higher interest rates than fixed-rate mortgages, particularly toward the later years of your loan. Even though there are caps involved in 5/1 ARMs, you may end up paying more per month.
- You’ll likely see interest rates rise during the adjustment period. Interest rates tend to trend upward, which can mean that you may experience an increase in your monthly payments.
- You’ll have to pay closing costs again to refinance. If you have plans to hold onto your ARM but then refinance later on, don't forget about closing costs. Much like when you first closed on your mortgage, you'll have to pay closing costs on a refinance. These extra costs could negate any potential savings you might have enjoyed from a fixed-rate mortgage.
- You may not save as much as you’d hoped. It's a good idea to make sure you're saving as many basis points as possible during the fixed-rate period for the ARM to be a worthy investment. A single basis point is a unit of measure which equals 1/100th of 1 percentage point, or01%. It affects your principal amount (the amount you owe) and your interest rate. In our 3.25% interest rate from earlier, if the interest rate rises to 3.5%, it would rise 25 basis points.
The Bottom Line
A 5/1 ARM loan has a fixed rate of interest for the first 5 years of the loan. After that, the interest rate will adjust annually over the remaining 25 years. It's different from a fixed-rate mortgage, which keeps the same interest rate for the duration of the loan.
Government loans also may carry a fixed rate, such as an FHA fixed interest rate. Most ARMs, including 10/1 ARMs and 5/1 ARMs, come with caps on how much interest rates can rise during their adjustment periods.
It's a good idea to consider all the ramifications of a 5/1 ARM for homeowners and understand how index and margin determine the adjustable interest rates. The ARM index is a base interest rate used to calculate the adjustable interest rate on a 5/1 ARM loan and margin refers to a number of percentage points you'll pay in addition to the index.
There are also caps on 5/1 ARMs . The initial cap limits the amount the rate can adjust the first time. The periodic cap indicates how much higher each adjustment can go. Finally, the lifetime cap puts a certain lifetime limit on the interest rate for an ARM.
Mortgage lenders can outline the various interest rates for borrowers prior to deciding. Your mortgage lender can help you go over the pros and cons before you decide on the right type of mortgage for you.
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