The process of finding and purchasing a home can be stressful for anybody. An often overlooked factor that can contribute to this stress is finding the right mortgage type. But when borrowers understand their options, they are more empowered to make the right decision based on their circumstances. Here’s what you need to know about a 5/1 ARM versus a 30-year fixed mortgage.
What Is a 5/1 ARM Loan?
A 5/1 ARM loan is an adjustable-rate mortgage that has a fixed interest rate for the first five years. After this initial five-year period, the interest rate will change — typically once yearly — based on market conditions. This means that borrowers will have the same monthly mortgage payment for the first five years of the loan, followed by a monthly payment that is subject to change.
Pros of a 5/1 ARM Loan
There are many reasons to consider a 5/1 ARM loan. Any borrower who is curious about this loan type should consider the benefits to determine whether it could be a good option for them.
1. Lower Initial Interest Rate
Compared to fixed-rate mortgages, adjustable-rate mortgages typically offer lower interest rates in the initial fixed-rate period. With this lower interest rate, borrowers can enjoy lower monthly mortgage payments for the first five years of their mortgage.
2. Flexibility
A 5/1 ARM can offer flexibility that borrowers may not find in other mortgage options. The lower initial interest rate can create more room in a borrower’s budget for other expenses, such as home renovations. This can be beneficial, especially in situations where a borrower is planning to sell the home before the end of the initial five-year period. It can also be beneficial for borrowers who are planning to refinance their mortgage before the initial fixed-rate period ends.
3. Potential for Savings
A lower initial interest rate means lower monthly mortgage payments. This can present a great opportunity for borrowers to build up their savings. Borrowers can then use these extra savings to manage fluctuating interest rates after the initial fixed-rate period ends. Or, borrowers could use these savings to contribute to a retirement account or other investment products.
Cons of a 5/1 ARM Loan
In addition to the benefits of a 5/1 ARM loan, it’s important to understand the potential downsides and risks of this mortgage type. These factors don’t have to be a dealbreaker, but they need to be taken into consideration.
1. Interest Rate Fluctuations
While borrowers can count on stability with a fixed rate for the first five years of a 5/1 ARM, they can expect interest rates to change after the end of that period. Because an adjustable interest rate is based on market conditions, there is no way to know exactly what an interest rate will change to. This results in unpredictability when it comes to monthly mortgage payments, which can make it difficult for borrowers to budget appropriately
2. Possible Higher Rates
After the initial five-year period, it’s possible that the interest rate of a 5/1 ARM can rise. In some cases, the change can be quite steep. This can result in a significant increase in monthly mortgage payments and may make it difficult for borrowers to stay current on their mortgage payments.
3. Potential Financial Risk
Some borrowers may plan to mitigate the risk of a fluctuating interest rate by selling or refinancing before the end of the initial five-year period. There is always the chance that borrowers may have a hard time selling their homes. Or, they might find that refinancing the home will not provide the benefits that they were hoping for. There is always the risk that the borrower might face higher mortgage payments that can cause financial hardship. In some cases, it might even mean the borrower has to foreclose on their home.
What Is a 30-Year Fixed Mortgage?
A 30-year fixed mortgage is a mortgage that has a fixed interest rate and a 30-year loan term. Because they have a fixed interest rate, borrowers can know exactly what their monthly mortgage payments will be throughout the life of the loan. These mortgages are repaid over a 30-year repayment period.
Pros of 30-Year Fixed Loan
A 30-year fixed loan is a popular mortgage option and for good reason. The benefits of this mortgage type include:
1. Stable Monthly Payments
Borrowers with a 30-year fixed loan will have the same interest rate throughout the entire mortgage repayment period. Because the interest rate will not change, neither will the monthly mortgage payments. This offers stability that can make it easier for borrowers to budget their mortgage payments over the life of the loan.
2. Lower Monthly Payments
One of the benefits of a 30-year fixed loan in particular is that it allows borrowers to spread out the repayment of their mortgage over a longer period. This can make homeownership more attainable by offering lower monthly mortgage payments than loans with a shorter repayment period.
3. Flexibility
A 30-year fixed loan also offers some level of flexibility for borrowers. Having a longer repayment period and lower monthly payments can allow for more flexibility when it comes to a borrower’s finances. Instead of spending a larger amount of their disposable income on mortgage payments, borrowers can use that money for other expenses or investments for their future.
Cons of a 30-Year Fixed Loan
While many borrowers opt for a 30-year fixed mortgage, that doesn’t mean that it’s right for everyone. Anyone who is considering this option should be aware of the potential downsides as well.
1. Higher Interest Rates
A fixed interest rate comes with many benefits, and those benefits are present with the 30-year fixed loan. But when compared to other loans with a shorter repayment period, 30-year fixed loans typically come with higher interest rates.
2. Slower Equity Building
One of the benefits of homeownership is being able to build equity. Homeowners with a 30-year fixed mortgage will build equity, but it will be at a slower rate than they would be able to with a shorter-term loan. This can delay a borrower's access to their home equity or their ability to sell the property.
3. Total Interest Payment
The monthly payments that come with a 30-year fixed loan can make paying off a home more manageable for many borrowers. However, this extended repayment period also means that borrowers will be paying interest over a longer period. This results in borrowers paying a higher amount of interest in the long run.
Factors to Consider When Choosing Between 5/1 ARM and 30-Year Fixed Mortgage
A 5/1 ARM and a 30-year fixed mortgage are both valid options for borrowers to consider. One or the other could be more beneficial for borrowers based on several factors. Here are a few things that borrowers should consider when deciding which option is better:
Financial Goals and Future Plans
A good starting point for borrowers is to consider their current financial situation as well as their anticipated future financial situation. This can help borrowers determine how much they can afford to spend on monthly mortgage payments. Borrowers should also think about their goals for homeownership and how long they anticipate staying in the home they are purchasing.
Level of Risk Tolerance
A 5/1 ARM has many benefits, but with those benefits come risks that borrowers wouldn’t face with a 30-year fixed mortgage. Borrowers need to consider the level of risk that they are comfortable taking when it comes to the potential for rising interest rates. It’s also important for borrowers to be realistic about their financial stability and whether they can afford higher monthly payments in the future.
Current Market Conditions
There are no guarantees when it comes to future market conditions, but borrowers can look at the current trends in interest rates to get an idea of what might be in the future. In addition to recent trends, borrowers can look at future interest rate predictions from experts and consider whether they are comfortable with those predictions.
Decision: 5/1 ARM vs. 30-Year Fixed
As with any mortgage type, there are pros and cons of both a 5/1 ARM and a 30-year fixed mortgage. Both are good options for potential homebuyers to explore and learn about. Each borrower must come to their own conclusion about which mortgage type is right for them.
Frequently Asked Questions
Is a 5/1 ARM a better option for me compared to a fixed-rate mortgage?
In some cases, a 5/1 ARM could be a better option. This is especially true if a borrower is hoping for more flexibility and is seriously considering selling or refinancing the home before the end of the initial five-year period.
Can I make additional payments toward the principal on 5/1 ARM and 30-Year Fixed?
In most cases, yes, borrowers can make additional payments toward the principal for both mortgage types. However, it’s important to check with your lender to see whether there are any penalties for doing so.
How does the initial interest rate on a 5/1 ARM compare to the rate on a 30-year fixed mortgage?
The initial interest rate on a 5/1 ARM is typically lower than the interest rate on a 30-year fixed mortgage.