What is a 5/1 ARM?
ARM is an acronym for adjustable-rate mortgage. A 5/1 ARM is a mortgage loan that has a fixed rate for the first five years, and then switches to an adjustable rate mortgage. Once a year after that initial five-year period, the interest rate can be adjusted up or down, depending on a number of factors.
The interest rate on a 5/1 ARM is made up of two parts, referred to as the index and the margin. When the index, which measures general interest rates, moves above the interest rate you originally paid on the loan, your interest rate will go up. If that index goes down, your interest rate may go down (not all ARMs are built to adjust downward, no matter the circumstances, so read your loan terms carefully). The margin is the amount added to the index to cover the lender’s fees.
Lenders may base their ARM rates on any number of indexes, including the Cost of Funds Index (COFI), one-year constant maturity Treasury (CMT), and the London Interbank Offered Rate (LIBOR). Before you decide on a 5/1 ARM, ask your lender which index they use and how much it has fluctuated historically. Also, find out where the index they use is published so you can keep an eye on it yourself.
The Consumer Financial Protection Bureau’s “Consumer Handbook on Adjustable-Rate Mortgages” says that your lender must notify you of any interest-rate adjustments at least seven months before they take effect. The notification must contain:
- An estimate of how much the new interest rate and new monthly mortgage payment will be.
- Any alternatives available to you.
- Contact information for a HUD-approved housing counselor.
A 5/1 ARM has some disadvantages:
- No sure way to budget. Consumers need to think about how often their mortgage payment is going to change, and the maximum amount it could go up. In order to remain financially solvent, they must consider the worst-case scenario and decide whether they can afford that monthly payment. 5/1 ARMs can be a tough for those who desire a sense of control.
- May cost much more in the long term. While a buyer can get into a 5/1 ARM with a lower payment, if he or she plans to remain in the home for more than five years it is likely the buyer will pay more for the mortgage over the life of the loan. Even if they stay only an extra five or six years, the increase in interest can easily eat up anything they saved during the first five years. It is important to crunch the numbers with a trusted lender before taking out a 5/1 ARM.
5/1 ARM example
There are a number of reasons a consumer may consider a 5/1 ARM. Among them:
- Rising interest rates. The primary draw of a 5/1 ARM is that the interest rate is an average of 1 percent lower than it is for a traditional 30-year mortgage. As of June 9, 2017, the Bankrate weekly average for a 30-year fixed rate mortgage is 4.04 percent, while the average for a 5/1 ARM is 3.44 percent.
- More bang for the buck. While 1 percent does not sound like a tremendous interest-rate discount, it can make a significant difference in your mortgage payment. For example, the payment (principal and interest only) on a $300,000 mortgage with a 30-year fixed rate of 4.04 percent, which is Bankrate’s latest weekly average, would be $1,439. The same mortgage at the current average 5/1 ARM rate of 3.44 percent would cost you $1,337 a month for the first five years. You’d have to opt for a less expensive house if you wanted to keep your payments at or below $1,337 with a 30-year fixed-rate mortgage.
Use Bankrate’s mortgage calculator to figure out how much your monthly payment would be.