What is a 5-year ARM?

How do 5-year ARMs work?

If you’re new to the world of mortgages, you may be wondering how adjustable-rate mortgages work. Unlike a fixed-rate mortgage, the interest rate of an ARM can increase or decrease throughout the life of the loan.

However, there are also hybrid ARMs that start with a fixed rate but adjust at regular intervals once the fixed-rate period ends. The frequency of the adjustments depends on your loan agreement.

For example, with a 5/1 ARM, the “5” indicates a fixed rate for the first five years. The “1” means that the rate adjusts once per year after that. However, with a 5/6m ARM, the rate adjusts every six months.

5-year ARM vs 30-year fixed

A 5-year ARM only has a fixed rate for the first five years, while a 30-year fixed mortgage provides a consistent rate for the entire term.

Lenders often offer an initial “teaser” rate on hybrid ARMs, so you may pay less at the beginning of the loan than you would with a comparable fixed-rate mortgage. However, once the introductory period ends, your payments may be much higher with an ARM vs. a fixed-rate mortgage.

On the other hand, a 5-year ARM may allow you to allocate more funds toward your mortgage’s principal at the beginning of the term. This strategy can reduce your overall balance, so you’ll have lower payments once the discounted rate ends.

With an ARM, you also won’t need to worry about closing costs from refinancing if rates decrease because the interest rate will automatically drop when it’s time for a readjustment.

» MORE: 15-year vs. 30-year mortgage

5/1 ARM pros and cons

There are benefits and disadvantages to choosing a 5/1 ARM, so it’s essential to weigh whether it’s a good choice for you. Here’s what you should keep in mind if you're seeking flexibility and affordability.

Pros

These are some of the advantages of a 5/1 ARM that make it appealing to many homebuyers on their house-hunting journey.

Lower initial rates and payments: ARMs often have a lower interest rate in the beginning than fixed-rate mortgages. With lower payments, you can allocate more directly toward the principal, so even if rates do increase later on, you’ll pay less because the balance is lower.

Potential for lower rates later: While there’s a good chance your rate could increase after the introductory period, it’s possible that your rate could decrease. It may be beneficial to opt for an ARM when interest rates are high and expected to drop in the coming years.

Good short-term plan: If you don’t plan to stay in your house long, you can enjoy the lower monthly payments, then move once it’s time for rates to adjust. It may also be a great option if you know your income will increase before the introductory period ends.

Cons

While a 5/1 ARM has its benefits, here are some drawbacks you should consider before choosing one.

Risk of increased rate and payments: While you’re guaranteed five years of consistent monthly payments with a 5/1 ARM, once the introductory period is over, your interest rate may increase. Reviewing the loan estimate and ensuring you can meet the highest payment is essential before choosing an ARM.

Less predictable: Unlike with a fixed-rate mortgage, you don’t know what your interest rate and payments will look like years down the road. It can make it challenging to plan for the future.

Slightly complicated: A fixed-rate mortgage is relatively easy to understand — you pay one rate for the entirety of the loan, and your payments never change. ARMs are a little more complex, as you’ll have to consider the index, margin and interest rate caps.

What to look for when shopping 5/1 ARMs

There are a few aspects you should look at when shopping for 5/1 ARMs.

“Specific to the terms of an ARM mortgage, it's important to know the index and margin, as well as the first adjustment,” said Shmuel Shayowitz, president and chief lending officer of Approved Funding.

When the fixed-rate period of your ARM ends, the lender will look at their chosen index, such as the U.S. Treasury Bill rate, the London Interbank Offered Rate (LIBOR) or the Cost of Funds Index (COFI), and add that index to the margin to calculate your new interest rate.

The margin is an extra percentage the lender sets in your loan agreement. It’s important to shop around to find mortgage lenders with a low margin to secure the best rate.

You should also look for the interest rate caps on an ARM to ensure you’ll be able to make the maximum payments.

For example, say a 5/1 ARM has a 1/2/6 rate cap structure. The “1” is the initial cap, meaning the first rate adjustment can’t exceed 1%. The “2” is the cap on subsequent adjustments, meaning they can’t exceed 2%. The last number — the “6” — is the lifetime cap, meaning the rate can never exceed 6% of your initial rate.

» MORE: Mortgage lender vs. bank

Bottom line

There are many types of mortgage loans available, and choosing the right one for your circumstance is just as important as finding the right home.

A 5-year ARM may be a solid choice if you plan to use what you save on monthly payments in the beginning toward the loan’s principal. It can also be great for people who plan to move before rates adjust.

However, it’s vital to ensure you can meet the highest monthly payments the loan could reach before signing onto an ARM.