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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, sometimes referred to as a hybrid mortgage, is usually a 30-year loan. The loan has a low, fixed rate (often referred to as the initial, introductory or teaser rate) for the first 3 – 10 years.
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 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?
So what do the two numbers in 5/1 ARM mean? The “5” means the mortgage has a fixed rate for the first 5 years. The “1” means that after the 5-year introductory period, the interest rate will adjust once a year.
When the rate adjusts, your mortgage will reflect the new interest rate for the entire year, regardless of whether interest rates rise or fall during that time. Your interest rate will automatically adjust at the end of each year over the life of the loan.
While the 5/1 ARM is one of the most popular ARM loans that lenders offer, there are other options, including the 10/1 ARM, the 7/1 ARM, the 7/6 ARM and the 5/6 ARM. By the way, if the number after the forward slash is 6, that means the loan adjusts every 6 months.
How Does a 5/1 ARM Compare to Other Mortgages?
Before committing to a 5/1 ARM, you may want to check out other mortgage options. Each comes with its own rates, terms, advantages and risks.
5/1 ARM vs. 5/6 ARM
Both loans are 5-year ARMs. Both typically carry lower interest rates than fixed-rate loans, but 5/1 ARMs readjust once a year, while 5/6 ARMs readjust every 6 months.
5/1 ARM vs. 7-year ARM
You can opt for a longer fixed term with a 7/1 or 7/6 ARM loan. You’ll get a longer introductory period with 7-year ARMs, but they usually have higher initial interest rates than 5-year ARMs.
5/1 ARM vs. 10-year ARM
The longest fixed-rate term available is a 10-year ARM. Because 10-year ARMs have longer fixed-rate terms, they’re less risky for borrowers who want to spend more time in their homes before the rate changes. On the downside, 10-year ARMs also have slightly higher initial interest rates than 5/1 ARMs.
5/1 ARM vs. 30-year fixed-rate mortgage
A 5/1 ARM typically has an interest-rate advantage over 30-year fixed-rate mortgages – at least during the introductory period. Between 2005 and 2021 (when tracking was discontinued by the Federal Reserve), the difference between the introductory rate for a 5/1 ARM and a 30-year fixed-rate mortgage has been 0.63%.
If you took out a $300,000 mortgage loan in 2014 when the difference between a 5/1 ARM loan and a 30-year fixed-rate mortgage was at its highest (1.15%), your monthly payments would have been:
- 30-year fixed-rate (4.17%): $1,462
- 5/1 ARM (3.02%): $1,268
You would save $194 a month in interest for the first 5 years of the ARM loan (or $11,640 total).
If interest rates rise after the introductory period, so will your monthly mortgage payments.
Let’s say that after 5 years, interest rates climbed to 6.02%. Your remaining loan balance would be $266,143 and your monthly mortgage payment would go up to $1,599. You’d be paying $331 more each month. Depending on your financial situation, that could be a significant hit to your budget.
5/1 ARM vs. 15-year fixed-rate mortgage
If you can afford the higher monthly mortgage payments of a 15-year fixed-rate mortgage, you’ll save thousands in interest, build equity faster and own your home sooner.
But if your budget is tight, you may be better off sticking with a 5/1 ARM or 30-year fixed-rate mortgage.
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 you and your partner found the perfect 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 can get a lower interest rate while you’re in your short-term home. You won’t have to worry about higher interest rates later on when the ARM adjusts, because you’ll sell the home before the rate can go up.
When interest rates are high
If you buy a home when interest rates are high, there’s a chance your rate could increase after the 5-year introductory period. But there’s also a chance interest rates could drop – and stay low – at the end of the introductory period.
If you’re deciding between a 5/1 ARM and a 30-year fixed-rate mortgage while interest rates are high, you’ll typically get a lower interest rate with a 5/1 ARM than you would with a 30-year fixed-rate mortgage.
You want to build equity faster
Because the interest rate on a 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 interest each month. That allows you to build home equity faster.
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 found a home you never want to leave or want to stay in for at least 10 years. The longer you stay in the 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
From 2010 – 2021, the average annual interest rate on 30-year fixed-rate mortgages stayed below 5%. But interest rates don’t work like gravity. The law of interest rates states that what goes down can always come up. If you aren’t going to save money 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 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.
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The Short Version
- A 5/1 ARM is an adjustable-rate mortgage that offers a low, fixed interest rate for its first 5 years, and then the rate adjusts each year after that for the life of the mortgage
- Historically, the 5/1 ARM has offered introductory interest rates that are lower than the 30-year fixed-rate mortgage and are closer to the 15-year fixed-rate mortgage
- Because a 5/1 ARM offers a lower initial interest rate, it can be a good choice for short-term buyers
Consumer Financial Protection Bureau. “With an adjustable-rate mortgage (ARM), what are rate caps and how do they work?” Retrieved December 2022 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 December 2022 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 December 2022 from https://fred.stlouisfed.org/graph/?g=Ij3P