If you’re looking to purchase a home, you’ve likely heard of adjustable-rate mortgages or ARMs. There are many types of ARMs on the market, but one of the most popular is a 5/1 ARM.
Understanding what this loan is and how it works can help you decide if it’s the right mortgage for your needs. In this article, we will discuss what a 5/1 ARM loan is and the pros and cons associated with it. We’ll also explore if this type of loan is right for your situation.
A 5/1 ARM loan is a type of adjustable-rate mortgage loan where the interest rate on the loan stays the same for the first five years and then adjusts annually for the next 25 years.
The “5” in the name of the loan refers to the number of years that the interest rate will stay fixed while the “1” refers to how often the interest rate can adjust after those five years. In most cases, the interest rate on a 5/1 ARM loan will adjust annually after those initial five years.
What Are 5/1 ARM Loans?
So what are 5/1 ARM loans?
A 5/1 ARM loan is a hybrid adjustable-rate mortgage. It combines features of a fixed-rate loan and an ARM, giving borrowers a fixed interest rate for the first five years of the loan and then allowing the interest rate to adjust annually for the remaining life of the loan.
The benefit of a 5/1 ARM loan is that it offers a lower interest rate than a traditional 30-year fixed-rate mortgage for the first five years of the loan. After that, the interest rate can increase or decrease depending on market conditions.
If you’re considering a 5/1 ARM loan, it’s important to understand how the interest rate will be determined after the initial five-year period. The interest rate will be based on an index, plus a margin.
The index is usually the yield on one-year Treasury bills, it is the benchmark used by most lenders, plus or minus a few percentage points. The margin is set by your lender when you apply for the loan and can’t be changed after you close on your home.
How Does a 5/1 ARM Loan Work?
You know its definition but how does it work exactly?
In order to understand how a 5/1 ARM works, it’s important to first understand how a traditional adjustable-rate mortgage works. With a traditional ARM, the interest rate is variable and adjusts periodically according to market conditions. The most common type of traditional ARM is a 1-year ARM, which means that the interest rate can adjust once per year.
With a 5/1 ARM, the interest rate is fixed for the first five years and then adjusts annually thereafter. That’s why it’s called a 5/1 ARM. The “5” stands for the number of years during which the interest rate is fixed, while the “1” indicates that it will adjust annually after those five years are up.
During the first five years of a 5/1 ARM, your monthly payments will be lower than they would be with a traditional ARM because you’re only paying interest on the loan amount for those first five years. After that, your payments will go up or down depending on how market rates have changed since you took out your loan.
Example of a 5/1 ARM Loan
5/1 ARM loans sound complicated but they aren’t, here are some examples of them.
Assuming a 200,000$ loan with interest rates of 6% for a 30-year fixed loan and 5.5% for a 5/1 ARM, the payment for the 30-year fixed loan is 1,199.10$ and the payment for the 5/1 ARM is $1,074.65. The difference in monthly payment is 124.45$.
Now let’s look at an example of a 5/1 ARM loan. Let’s say the interest rate on your loan is 4%, but it can adjust upwards or downwards every year after the fifth year. You have a margin of 2%. That would mean that if rates went up 1% overall, your new interest rate would be 6%. And if rates fell by 1%, you would enjoy a lower rate of 2%.
But there’s more to understand about how 5/1 ARMs work before you make this decision. In order to get the lowest possible monthly payment, you may want to consider making a larger down payment so that you can keep your loan amount lower and avoid having to pay private mortgage insurance or in short PMI.
Pros and Cons of 5/1 ARM Loans
There are pros and cons to everything in life, and this includes 5/1 ARM loans. So before you take one out you need to understand them first.
Pros:
- It offers borrowers a lower interest rate than a traditional 30-year loan
- It gives you the flexibility to sell or refinance your home before the end of the fixed-rate period without penalty.
- It’s easily attainable
Cons:
- The interest rate and monthly payments can go up or down over the life of the loan
- They have interest rate caps and these caps may not be high enough to keep up with market rates
- They typically have shorter terms than fixed-rate mortgages
Pros
The biggest advantage is that it offers borrowers a lower interest rate than a traditional 30-year fixed-rate mortgage. This can save you thousands of dollars in interest over the life of the loan.
Another benefit of an ARM loan is that it gives you the flexibility to sell or refinance your home before the end of the fixed-rate period without penalty. This can be advantageous if you expect to move again in a few years or if market rates rise and you want to lock in a lower rate. On top of all that, they are quite easy to obtain.
Cons
One such drawback is that, because they are adjustable-rate mortgages, the interest rate and monthly payments can go up or down over the life of the loan. This can make budgeting for a mortgage payment difficult.
Another potential drawback is that many ARMs have interest rate caps, which limit how high the interest rate can go in an adjustment period. However, these caps may not be high enough to keep up with market rates, meaning that borrowers could still end up paying more than they anticipated.
Finally, ARM loans typically have shorter terms than fixed-rate mortgages, which means that borrowers may end up having to refinance sooner than they would with a fixed-rate loan.
Is a 5/1 ARM Loan Worth It?
But the main question is are they worth it?
A 5/1 ARM Loan can be a great option for many homebuyers. With a 5-year fixed interest rate and a 1-year adjustable rate, you have the security of a fixed interest rate for 5 years.
After that, your interest rate will adjust annually, but only by a maximum of 2%. This makes a 5/1 ARM Loan a good option for people who expect their incomes to rise over time or who plan on selling their home before the end of the 5-year period.
Bottom Line
The 5/1 ARM loan sounds complicated. But in reality, they are quite easy to understand. They can benefit many and they have a lot to offer.
They do come with some risks so if you’re considering a hybrid ARM, it’s important to understand how these loans work. All in all, if you are responsible and determined this type of loan is for you.
