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

 When shopping for a mortgage, there are several options to consider. The biggest consideration is whether you want a fixed-rate or variable-rate loan, otherwise known as an adjustable-rate loan. A 5/1 ARM offers some of the benefits of both types of interest rates. To pick the right option, you must understand exactly how a 5/1 ARM works and what it offers. 

What Is a 5/1 ARM Loan?

A 5/1 adjustable-rate mortgage (ARM) is a home loan that has a fixed interest rate for the first 5 years of the loan, followed by an adjustable rate. 

5/1 ARM Terms to Familiarize

When considering a 5/1 ARM for your home loan, it’s important to understand the loan terms. These terms will help you understand how the loan and repayment period work. 

• Fixed or initial rate period: This is the period that the loan will stay at a fixed interest rate. Since it is at the beginning of the loan, it might also be referred to as the initial rate period. With a 5/1 ARM, the fixed or initial rate period is 5 years. 
• Adjustment intervals: After the initial rate period ends, your loan will be subject to a variable interest rate. The adjustment interval will detail how often the rate will be adjusted. With a 5/1 ARM, the interest rate adjusts once per year after the initial rate period. 
• Initial adjustment cap: Even after the initial rate period is over, you have some control over your interest rate. The initial adjustment cap limits how much your interest rate can be raised at the first adjustment. Your interest rate can be raised by 2% at most, no matter what the current market conditions are. 
• Periodic rate cap: There is a cap on how much the interest rates can be raised in future years. This rate is also 2%. 
• Lifetime cap: Another cap limits the interest rate increase throughout the loan's lifetime. As long as the loan is active, the interest rate cannot rise more than 5%. 

How Does a 5/1 ARM Work?

A 5/1 ARM is a mortgage with a fixed rate for the first 5 years of the loan, followed by a rate adjusted yearly based on current market conditions. Once the initial rate period is over, the rate can increase or decrease. 

Your monthly payment amounts can also change each time the interest rate changes. This is because your mortgage is designed to be paid off over a set number of years — typically 30 years — regardless of the interest rate adjustments. Each time the interest rate is adjusted, your lender will recalculate the monthly payments to ensure the mortgage will be paid off on time. 

Example of a 5/1 ARM Loan

A 5/1 ARM can be appealing because the interest rates are often lower than fixed-rate loans. However, this interest rate is only guaranteed for the first 5 years of the loan, so some risk is involved.

For example, let’s take a look at a mortgage for $300,000. The 5/1 ARM comes with an initial interest rate of 6%. For the first 5 years, you would be locked in at a fixed monthly payment based on the fixed interest rate. In this case, let’s say the monthly payment is $1,798.65 for principal and interest only. 

If interest rates trend higher throughout the initial period, your interest rate might increase at the first adjustment. If it were to rise to 7.5% — within the 2% cap limit — your monthly payments could be increased to $2,097.64. Throughout the remainder of a 30-year loan term, your interest rate could be raised to 11% at most. If that were the case, your monthly payments could be as high as $2,856.97.

When Should You Consider a 5/1 ARM?

A 5/1 ARM can be a good mortgage option, but there are considerations. Here are some situations when one might be right for you.

• You don’t plan to stay in the house for more than 5 years: If you plan to sell the home within 5 years, a 5/1 ARM can be a good way to lock in a lower interest rate. 
• You’re at the start of your career: It might be a good idea to lock in a lower rate if you’re starting a career and expect a significant increase in income within the next 5 years. This will allow you to lock in a lower interest rate — and lower monthly payments — for the beginning of the mortgage and allow you to save and budget for possible higher monthly payments later.
• You’re willing to take the risk: The bottom line is that if you’re willing to take the risk of the interest rate rising considerably after the initial rate period ends, you might want to consider a 5/1 ARM. If you’re financially stable and able to handle the maximum payment increase, this type of mortgage could make sense. 

Pros and Cons of 5/1 ARM

Now that you know how the 5/1 ARM works and when to consider it, it’s time to look at the pros and cons of this mortgage type. 

Pros

Some upsides come with a 5/1 ARM, including:

• Lower initial interest rate: The initial interest rate of a 5/1 ARM is typically lower than fixed-rate mortgages.
• Allows for lower interest rates later: While the interest rate could increase after the initial rate period ends, the interest rate could also decrease later. 
• Can be good for a starter home: If you’re planning on your house being a starter home that you’ll move out of within a few years, a 5/1 ARM could help you have a lower interest rate throughout the entire time you’re in the home. 

Cons

There are some potential downsides to consider as well.

• Lower rate might not be worth it: Although the lower initial interest rate can be a pro, it’s important to look at the whole picture. The difference in the initial interest rate compared to a fixed-rate loan might not be worth the headache and possibility of higher payments in the future. 
• Can be risky: When you take out an ARM, you take the risk of your interest rate and monthly payments increasing significantly over the lifetime of the loan. 
• Can be complicated: There are several terms to understand, making an ARM more complicated than a standard fixed-rate loan.

5/1 ARM vs. Other ARMs

There are other ARMs, with the 7/1 and 10/1 being the most common. These ARMs work similarly to a 5/1 ARM. The only difference is that the 7/1 ARM has an initial interest rate period of seven years, and the 10/1 ARM has an initial interest rate of 10 years. Due to these longer fixed-rate periods, the interest rates on these ARMs might be slightly higher than the 5/1 ARM. 

5/1 ARM vs. Fixed Rate Mortgage

A 5/1 ARM and a fixed-rate mortgage are quite different. The 5/1 ARM only has a fixed interest rate for the first 5 years, whereas a fixed-rate mortgage has a fixed interest rate for the lifetime of the loan. The interest rate of a 5/1 ARM is typically lower than that of a fixed-rate mortgage for the initial 5 years. These savings can be an attractive idea, but taking the risk of monthly payments increasing later might not be worth it for everybody. A fixed-rate mortgage offers the stability of fixed monthly payments throughout the lifetime of the loan, making it easier to budget for the future. 

Compare the Best 5/1 ARM Loans From Benzinga’s Top Providers

If considering a 5/1 ARM, consider some of the best 5/1 ARM providers.

Is a 5/1 ARM Right for Me?

Picking the right mortgage will depend on your financial situation and long-term goals. Before you apply for any mortgage, consider your goals and finances and research the best mortgages. Anyone who gets a 5/1 ARM should ensure they can handle the maximum increase in payments after the initial rate period ends.

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