What is a 5/1 ARM loan and how does it work? Is it a good idea to get one? We’ll cover the basics of how these so-called hybrid mortgage loans work and who should or shouldn’t get one.
Table of Contents
What is an ARM Loan?
The acronym ARM stands for adjustable-rate mortgage. An adjustable-rate mortgage is a type of home loan where the interest rate can change over time based on a designated interest rate index.
The 1-Year Constant Maturity Treasury (CMT) is a commonly-used interest rate index today.
The London Interbank Offered Rate (LIBOR) was commonly used in the past, but it has since been phased out.
The interest rate for an adjustable-rate mortgage is calculated by adding a margin set by the lender to the index. For example, if the index is 2.50% and the margin is 2.50%, then the fully-indexed interest rate equals 5.0%.
Interest rates on adjustable-rate mortgages can both decrease and increase over the life of the loan, depending on the movements of the index. This means your monthly payment could both increase and decrease over time as well.
Though the index changes over time, the margin will never change over the life of the loan.
The most common adjustment frequencies for adjustable-rate mortgages are once per year or every six months.
Most HECM reverse mortgages also tend to have adjustable rates.
What is a 5/1 ARM Loan?
A 5/1 ARM mortgage is a type of adjustable-rate mortgage that offers a fixed interest rate for the first five years of the loan term. Once the initial five years have passed, the interest rate and monthly payment are adjusted annually based on the index for the remaining 25 years of the loan.
The “5” in “5/1” ARM represents the number of years the interest rate is fixed. The “1” represents how often the interest rate can potentially change. In this case, it’s once per year.
You may also run across the 5/6 ARM; this type of loan also has a fixed interest rate for the first five years of the loan, but the interest rate is adjusted based on the index every six months for the remainder of the loan term.
Because the 5/1 ARM mortgage has both a fixed and variable interest rate during the loan term, it is commonly referred to as a hybrid mortgage.
When it comes to adjustable-rate mortgages, the shorter the fixed-rate period, the lower the initial interest rate. In other words, a 5/1 ARM typically has a lower starting interest rate than a 7/1 ARM, which has a lower starting interest rate than a 10/1 ARM – which has a lower starting rate than a 30-fixed. The longer the fixed period, the higher the rate you’ll pay on the mortgage.
5/1 ARM Mortgage Rate Caps
Though the interest rate can change during the last 25 years of the loan, it can’t go crazy. There are limits on the rate adjustments. This provides a measure of protection and stability so your monthly payment doesn’t go nuts even if interest rates do.
The first rate adjustment at the end of the initial fixed-rate period is governed by the initial adjustment cap. For example, if the initial adjustment cap is 2%, the interest rate on the loan cannot increase more than 2% above the starting interest rate – even if the index has increased much more than that.
There is a cap on subsequent rate adjustments as well. This cap, which is known as the periodic adjustment cap, limits how much the interest rate can change during each adjustment period after the initial rate adjustment.
There is also a lifetime adjustment cap, which sets a maximum interest rate beyond which the rate can never increase over the life of the loan. No matter how much the index increases, the interest rate can never exceed the lifetime adjustment cap.
Interest rate caps are often represented using a shorthand notation such 5/2/5 or 2/2/5. The first number represents the initial adjustment cap, the second number represents the periodic adjustment cap, and the last number represents the lifetime cap.
For example, let’s assume we have a 5/1 ARM mortgage with 5/2/5 rate caps and an initial interest rate of 3%.
Again, the “5/1” means the interest rate is fixed for the first five years, then adjustable annually for the remaining 25 years of the loan term.
The “5/2/5” means the first rate adjustment (represented by the first “5”) cannot exceed 5% above the starting interest rate. In other words, the interest rate cannot exceed 8% at the first rate adjustment.
The “2” represents the periodic rate adjustment, which means the interest rate cannot change more than 2% at each adjustment after the initial rate adjustment.
The last “5” represents the lifetime cap, which means the interest cannot exceed 5% above the initial interest rate regardless of what happens with the index.
Why Get a 5/1 ARM Loan?
So, what is a 5/1 ARM best used for? A 5/1 ARM loan could be a good option if you don’t plan to live in your home for more than five years. Because the bank guarantees the rate only for the first five years, the rate is often much lower than what you would pay for a comparable 30-year fixed mortgage. This reduces your monthly payment and frees up cash that can be used for other financial goals or expenses.
A 5/1 ARM is also a good option if you plan to pay down your loan balance rapidly. Again, the initial interest rate is typically much lower than a comparable 30-year fixed mortgage, so more of your payment will go towards the principal.
If you pay down your principal rapidly, your loan balance will be substantially reduced by the time the interest rate starts to adjust. Even if the rate hits the caps, the smaller loan balance will limit your payment increases.
In fact, if you’ve paid down your balance enough, your payment could decrease even if the interest rate increases to the maximum allowed.
Who Should Avoid a 5/1 ARM Mortgage?
The 5/1 ARM loan is a good option, but it’s important to consider the potential risks as well. It’s best to avoid a 5/1 ARM if you can barely afford the payments during the initial fixed-rate period.
Again, the payment could increase at the end of the fixed-rate period if the index increases. If the payments become unaffordable, you could be at risk of foreclosure.
We recommend opting for a 5/1 ARM only if you can comfortably manage the payments even if the rate increases to the caps.
What is the difference between a 5/1 and a 7/1 ARM?
The 5/1 and 7/1 ARMs are both hybrid adjustable-rate mortgages. In other words, the interest rate is fixed at the beginning of the loan, then becomes adjustable on an annual basis after a certain number of years. The difference between a 5/1 ARM and a 7/1 ARM is the number of years the rate is fixed. For the 5/1 ARM, the rate is fixed for the first 5 years of the loan, then adjustable for the remaining 25 years of the loan. For the 7/1 ARM, the rate is fixed for the first 7 years of the loan, then adjustable for the remaining 23 years of the loan. The 5/1 ARM tends to have a slightly lower initial interest rate than a 7/1 ARM because of the shorter fixed-rate period.
Why are 5/1 ARMs referred to as hybrids?
The 5/1 ARM is referred to as a hybrid loan because the interest rate is fixed for the first 5 years of the loan, then becomes adjustable on an annual basis for the remaining 25 years of the loan.
How long does a 5/1 ARM last?
A 5/1 ARM is a fully-amortizing 30-year mortgage, which means it pays off in full at the end of 30 years. The 5/1 ARM is often referred to as a hybrid loan because the interest rate is fixed for the first 5 years of the loan, then becomes adjustable annually for the remaining 25 years of the loan.
Is it a good idea to have a 5/1 ARM?
A 5/1 ARM is a great loan option if you don’t plan to remain in your home past five years. A 5/1 ARM often has a substantially lower interest rate than a comparable 30-year fixed mortgage, which can result in significant payment savings. However, it’s important to also consider the risks. If you can barely afford your payments during initial fixed-rate period, you could be at risk of foreclosure if your payment increases in the future.