When you’re looking to buy or refinance a home, odds are you’ll need to take out at least one loan to finance the deal. While there are various loan types and terms you can pick from, you’ll often need to decide between fixed-rate loans or so-called adjustable-rate mortgages or ARMs.
But you may also run into a type of ARM loan with an initial fixed interest rate and a variable interest rate after a set period. These are often called a 5/1 ARM loan, though they also come in other forms. Let’s break down 5/1 ARM loans in detail and explore whether these loans will be suitable choices for your real estate goals.
What is a 5/1 ARM Loan?
Put simply, a 5/1 ARM loan is a type of adjustable-rate mortgage loan that features a fixed interest rate for the first five years of the loan’s term. After this five-year period has passed, the 5/1 ARM loan’s interest rate becomes adjustable for the remainder of the term.
For most 5/1 ARM loans, the introductory five-year interest rate is usually called the “teaser rate” because it is typically much lower than comparable rates you get for fixed-rate mortgage agreements. You can sometimes find these loans for 7 or 10-year fixed-rate timeframes, but the 5-year rate is the most common by far.
As soon as the fixed-rate period for the loan is over, the interest rate for the ARM loan will go up or down depending on a variety of factors like current market rates. Of course, the interest rate is still capped to a certain extent, which means the interest rate will only go up by a certain maximum amount at any one time. Adjustments usually happen once per year.
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How a 5/1 ARM Loan Works
A 5/1 ARM loan works by drawing people to accept the loans through the low introductory interest rate offer. Once the initial five-year term is over, the lender calculates a new rate.
Typically, the new rate is calculated by adding your mortgage’s margin and an index number like the Cost of Funds Index (COFI) or Constant Maturity Treasuries (CMT). The Secured Overnight Financing Rate or SOFR is another index that may be used to calculate the adjusted interest rate.
When you consider signing a 5/1 ARM loan contract, you’ll come across a variety of important terms. These include:
The fixed or teaser rate, which specifies how long the interest rate remains fixed and low at the beginning of the loan term. For a 5/1 ARM loan, the “5” denotes the teaser rate
The adjustment interval, which tells you how often the interest rate adjusts after the fixed-rate portion of the loan’s term is concluded. For a 5/1 ARM loan, the “1” denotes the adjustment interval since the interest rate adjusts once per year
The initial cap, which limits how much the interest rate can adjust upward the first time an adjustment is made regardless of other market conditions. For example, a normal 5/1 ARM loan has an initial cap of 2%. Because of this, you will not need to worry about your adjustable mortgage rate increasing by more than 2% on year 6 of the loan’s term
Caps on subsequent adjustments, which affect each adjustment after the first interest rate change
The lifetime cap, which is the total lifetime limit on rate increases. For example, a typical 5/1 ARM loan may not allow the mortgage interest rate to increase by more than 5% as long as the original signer holds the loan
5/1 ARM Loan Example
No matter the loan contract you have signed, any adjustable or variable interest rate always changes based on marginal rates according to the indexes they’re tied to. Say that a 5/1 ARM loan has a 3% margin and its index is 3%. In such a scenario, the interest rate would adjust to 6% after the teaser rate timeframe has concluded.
For example, imagine that you wish to purchase a $250,000 home with a 25% down payment of $62,500. That means you’ll only have $187,500 left for a 5/1 ARM loan.
In this case, you could save hundreds of dollars per month for the first five years of the loan’s term since you’ll have a lower than market average interest rate to contend with. However, once the five-year teaser rate is finished, you may wish to sell your home when the interest rate goes up or refinance your loan to secure a more stable, less volatile interest rate.
5/1 ARM Loan Pros & Cons
It can be tough to determine whether a 5/1 ARM loan is a good choice for your upcoming home purchase. So let’s take a closer look at the advantages and disadvantages of this unique loan type.
Pros of 5/1 ARM Loans
All adjustable-rate mortgages have their benefits. The specific pros of 5/1 ARM loans include:
A lower than average initial interest rate. Since interest rates are allowed to change in the future, 5/1 ARM loans are designed with an intentionally lower than market average interest rate at first to draw people to the loan. This may give buyers who need financial flexibility the breathing room they need to purchase a house in the first place or spend the money they save on interest for other things.
The possibility that you may pay less interest overall. If you put the money you save from the lower initial interest rate toward the principal, you may pay down more of your loan more quickly than you would otherwise. This would result in the future interest rate also incurring less of a charge against you since the principal will be lower. Note that this benefit only kicks in if you are forward-thinking enough to take advantage of it.
They may be good for short-term homeownership. For example, if you are looking to buy a starter home and know that you’re moving just a couple of years, you could get out of the home before the interest rate adjusts, and you lose out on the meager teaser rate. Of course, this is really only a benefit if you have a solid knowledge of your short-term future and know that you’ll be able to move before the interest rate increases, which is somewhat dependent on the housing market and other circumstances, like your income security.
Cons of 5/1 ARM Loans
But you should also be aware that 5/1 ARM loan also have several disadvantages, including:
There’s a possibility for higher mortgage payments in the long term. Since the teaser rate for 5/1 ARM loans is lower than the market average, long-term payments for the interest rate after the introductory timeframe are often more expensive than average. This is how lenders make money off of these loan contracts.
You may pay more in interest over time as well. Again, since interest goes up after five years, you may also have to pay more of that interest over time if you don’t pay down enough of your loan’s principal during the initial five-year timeframe.
If you refinance to a fixed-rate loan, you’ll have to pay extra fees. Some homeowners believe they can circumvent the high-interest rates after the five-year teaser rate by refinancing. While this is technically true, keep in mind that you’ll also have to pay extra fees and closing costs whenever you refinance your mortgage. This can be between 3% and 6% of the total loan amount in some cases, which can be quite a lot of your savings.
The interest rate difference may not be worth it. As interest rates go down overall, the yield curve for the housing market narrows. In a nutshell, the yield curve affects the difference between adjustable-rate and fixed-rate mortgages. In this way, 5/1 ARM loans are only really worth it if you will save a significant amount of cash on the front end of the deal. If the difference is only about 10 basis points (or 10 hundredths of a single percentage point, or 0.1%), a 5/1 ARM loan may not be worth it in the end.
5/1 ARM Loan vs. Fixed-Rate Mortgage
As you can see, 5/1 ARM loans could be a good choice for certain homebuyers. But fixed-rate mortgages might be more appropriate depending on your budget and other specifics.
For example, fixed-rate mortgages only have a single interest rate for the loan’s entire lifespan. This makes financial planning for the mortgage and budgeting on a month-to-month basis much simpler. The rate isn’t tied to an index rate or any other underlying benchmark and never changes. This predictability and stability are attractive to many current and would-be homeowners.
On top of that, you have to keep in mind that the variable or adjustable interest rate after the five-year teaser rate could be higher than the fixed-rate interest you would see with a traditional mortgage. If you are a first-time homebuyer, a traditional or fixed-rate mortgage could be beneficial since you’ll be able to estimate the total cost of borrowing over the loan’s lifespan. This is impossible to do with a 5/1 ARM loan.
When Should You Consider a 5/1 ARM Loan?
Like many things in real estate, 5/1 ARM loans are only appropriate when the circumstances are right.
For example, when interest rates are high, 5/1 ARM loans are a great option, especially for first-time homeowners. That’s because the five-year teaser rate will be lower than the current market average. In this way, homeowners can be sure to save at least some money for the first five years of their mortgage payments.
In fact, 5/1 ARM loans first became available in 1981, when the average rate for 30-year mortgage loans rocketed past 18%. Homeowners then used 5/1 ARM loans to continue purchasing real estate.
But on the flip side, if interest rates are currently low, 5/1 ARM loans aren’t necessary or even wise. For example, fixed-rate mortgages were at record lows in September 2020, so there wasn’t any reason for homebuyers to use 5/1 ARM loans to save just a couple of tenths of a percentage point.
As noted above, 5/1 ARM loans could also be a good idea if you know for certain that you will be out of the loan contract (from moving or selling the home) before the five-year teaser rate has concluded. In this case, you can take full advantage of the low-interest rate of the teaser period and get out before the adjustable rate has an opportunity to affect your wallet negatively.
Alternatively, 5/1 ARM loans could be a good choice if you are very financially responsible and want to take the money you’ll save from the first five years of the loan and put it toward your mortgage principal. This could allow you to pay off your house more quickly and even mitigate the potential financial risk you might face with a high adjustable rate after the teaser concludes.
On the flip side, if you plan to live in a house for quite a while, a fixed-rate mortgage is certainly easier to predict and may also be more affordable in the long term (since the adjustable rate for a 5/1 ARM loan could end up being higher than the average fixed interest rate).
In the end, it’s up to you to decide whether a 5/1 ARM loan is a good choice for your homeownership needs. Consider your budget carefully, think about how long you’ll live in a given piece of real estate, and try to choose a loan that’s beneficial for the current market you find yourself in.
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