When you’re looking for a mortgage loan, you’ll often be offered a choice between a fixed-rate mortgage and an adjustable-rate mortgage (ARM).
While there are many different types of ARM loans, the 5/1 ARM is among the most popular, usually offering lower interest rates in comparison to 30-year fixed-rate mortgages.
But what is a 5/1 ARM, and is it the right option for you?
What Is an Adjustable-Rate Mortgage (ARM)?
Let’s start with a quick overview of what an ARM is and how it works.
An ARM is usually a 30-year loan. The first 3 – 10 years of the loan have a low, fixed rate that is often referred to as the teaser rate or introductory rate.
At the end of the introductory period, the mortgage rate adjusts (think: goes up or down) once a year.
When your interest rate adjusts, your new annual rate will be based on a variety of factors, including:
- Index rate: It’s the financial benchmark a lender uses to decide how much interest they can charge. The index rate is usually based on rates set by the Federal Reserve and other international banking standards, like the London Interbank Offered Rate (LIBOR), which is being phased out at the end of 2021 in favor of the Secured Overnight Financing Rate (SOFR).
- Margin: The margin is the amount above the index rate that the lender charges to borrow money. The margin is usually based on a borrower’s credit score and debt-to-income (DTI) ratio.
The terms of your mortgage will also determine how much your interest rate will change each year. According to the Consumer Financial Protection Bureau, your ARM should include these three caps (aka interest rate limits):
- Initial adjustment cap: This is how much the interest rate can increase the first time it’s adjusted after the end of the introductory, fixed-rate period.
- Subsequent adjustment cap: This is how much the interest rate can increase in all the following adjustment periods.
- Lifetime adjustment cap: This is how much the interest rate can increase in total over the life of the loan. For example, if your lifetime cap is 8%, the lender can’t charge an interest rate higher than 8%. Even if the current average rate for mortgages is 10%, the lender can’t go higher.
What Is a 5/1 ARM?
When lenders advertise ARM loans, they’re usually represented by two numbers. The first number indicates the length of the introductory period. The second number indicates the number of years between interest rate adjustments.
So, a 5/1 ARM is an adjustable-rate mortgage with a fixed rate for the first 5 years of the mortgage. After the 5-year introductory period, the interest rate will adjust once each year.
There are other ARM options, including the 10/1 ARM, the 7/1 ARM and the 5/6 ARM, but the 5/1 ARM is one of the most popular ARM loans lenders offer.
How Does a 5/1 ARM Compare to a 15-Year Fixed-Rate Mortgage?
Since the Federal Reserve started tracking interest rates for the 5/1 ARM in 2005, interest rates for the 5/1 ARM (introductory), 15- and 30-year fixed-rate mortgages have looked like this:
|Year||5/1 ARM||15-Year Fixed||30-Year Fixed|
Historically speaking, the difference between the introductory rate for a 5/1 ARM and a 15-year fixed-rate mortgage has been less than 0.3%. While the introductory rate on the 5/1 ARM has generally been lower, occasionally, the 15-year fixed-rate mortgage has been more affordable.
But, if you’re paying off a mortgage over 15 years instead of 30, you’ll have a higher monthly mortgage payment.
How much higher? Let’s use the 2020 rates with a $250,000 home mortgage loan:
- 15-year fixed mortgage: $1,679 monthly payment
- 30-year fixed mortgage: $1,069 monthly payment
- 5/1 ARM: $1,063 monthly payment
For the first 5 years, the difference between the 15-year mortgage and the 5/1 ARM will be $616. Of course, if interest rates go up, the difference between the monthly payments will shrink.
If you can afford the higher monthly payment, a 15-year fixed-rate mortgage can shave off thousands in interest, help you build equity (the current value of your home minus what you owe on your mortgage) and let you own your home faster.
On the other hand, if that extra $616 a month is more than you can afford, you’re better off sticking with a 5/1 ARM or 30-year fixed-rate mortgage.
Annual percentage rates (APRs) on an ARM
When you compare fixed-rate loans to ARM loans, you’ll notice that the APR is higher on the ARM even though the interest rate is lower. That’s because the APR reflects the overall cost to borrow, including fees and other charges.
Still, when lenders present an APR for an ARM, it doesn’t reflect the maximum interest rate of the loan.
When Is a 5/1 ARM a Good Idea?
If you’re a home buyer looking to get a low interest rate, there are lots of reasons why a 5/1 ARM can be a good mortgage option for you.
When you don’t plan to stick around
Let’s say you’re a first-time home buyer, and you found an amazing condo in the city or maybe you and your partner found a great starter home. In either case, you know you won’t be there for long.
A 5/1 ARM can be a good option here because you’ll be able to get a lower interest rate while you’re in your short-term home, and you can avoid higher interest rates later because you’ll get a new mortgage when you sell and move into a different home.
When interest rates are high
Interest rates have been at historic lows since 2010. The average annual interest rate on 30-year fixed-rate mortgages has stayed below 5%. But, unlike gravity, the law of interest rates states that what goes down must eventually come up.
If you buy a home when interest rates are high, there’s a chance that your rate could increase after the 5-year introductory period. But there’s also a chance that interest rates could drop – and stay low – at the end of the introductory rate.
You want to build equity faster
Home equity is the value of a home minus what you owe on your mortgage.
Because the interest rate on the 5/1 ARM is lower than a 30-year fixed-rate mortgage, you can pay more toward the mortgage balance (aka principal) and less toward the interest each month. That allows you to build equity faster.
When your credit isn’t amazing
Let’s say you have a good credit score that’s around 620 – 640.
While it’s high enough to qualify for a home loan with most lenders, you may not get the lower interest rates you’d get with a higher credit score.
Depending on current interest rates, you may be able to get a lower interest rate with a 5/1 ARM than you would with a fixed-rate mortgage. Plus, you could use that 5-year low, initial rate period to work on and improve both your credit score and your debt-to-income (DTI) ratio.
When Is a 5/1 ARM Not a Good Idea?
A 5/1 ARM won’t be right for everyone. Here are a few times when a fixed-rate mortgage may be a better option:
When you’ve found your forever home
Let’s say you’ve started a family, and you’ve found an amazing home that you never want to leave. The longer you stay in your home, the greater benefit you’ll get from a fixed interest rate. And you (and your budget) won’t have to deal with the payment unpredictability of an ARM.
When interest rates are low
If interest rates are already low, a 5/1 ARM may not offer much of a break in interest rates. In some cases, you may even get a lower interest rate on a 30-year or 15-year fixed-rate mortgage.
If you aren’t going to save with an ARM, you may be better off taking advantage of the stability of a fixed-rate mortgage.
When you don’t know what’s coming next
Life doesn’t always work out as planned. Maybe you’re thinking about changing careers in 5 years. Or maybe you’re worried about future financial challenges.
Unless you’re sure that interest rates will drop in the next 5 years and stay low (which is impossible to predict!), an adjustable-rate mortgage can add a lot of unpredictability to your budget.
A fixed-rate mortgage can provide you with more stability – at least when it comes to your mortgage payments.
The 5/1 ARM: Is It Right for You?
If you’re looking for a short-term loan option with a low interest rate, from year 1 – 5, a 5/1 ARM can be a helpful short-term solution. Just keep in mind that, starting in year 6, your interest rate might go up.
Depending on the market and your ability to anticipate an increase, you may be able to make your mortgage payments more affordable by refinancing. But you’ll need to make sure that your income and credit are in a good place before you try to refinance.
When all is said and done, going with an ARM or a fixed-rate mortgage will be up to you and your lender.
Federal Reserve Bank of New York. “Transition from LIBOR.” Retrieved November 2021 from https://www.newyorkfed.org/arrc/sofr-transition
Consumer Financial Protection Bureau. “With an adjustable-rate mortgage (ARM), what are rate caps and how do they work?” Retrieved October 2021 from https://www.consumerfinance.gov/ask-cfpb/with-an-adjustable-rate-mortgage-arm-what-are-rate-caps-and-how-do-they-work-en-1951/
Federal Reserve Bank of St. Louis. “Comparison of 30-year fixed-rate, 15-year fixed-rate and 5/1-Year adjustable-rate mortgage average in the United States since 2005.” Retrieved October 2021 from https://fred.stlouisfed.org/graph/?g=IgZe
Federal Reserve Bank of St. Louis. “30-year fixed-rate mortgage average in the United States since 2010.” Retrieved October 2021 from https://fred.stlouisfed.org/graph/?g=Ij3P