What is a 5/1 ARM?
A 5/1 adjustable-rate mortgage, or ARM, is a mortgage loan that has a fixed rate for the first five years, and then switches to an adjustable-rate mortgage for the remainder of its term. Once a year after that initial five-year period, the interest rate can be adjusted up or down, depending on a number of factors.
For the first five years of the 5/1 ARM, borrowers pay a fixed interest rate. However, after that time, the interest rate will be adjusted once per year, which is what the “1” in “5/1” refers to.
The variable interest rate on a 5/1 ARM is determined by an index, which could be based on the Cost of Funds Index (COFI), the one-year constant maturity Treasury rate (CMT), or the London Interbank Offered Rate (LIBOR).
The index may move above the interest rate the borrower originally paid on the loan, in which case her interest rate will go up. If that index goes down, her interest rate may go down. Additionally, lenders charge a margin on top of the index rate to cover the lender’s fees.
While a buyer can get into a 5/1 ARM with a lower payment, if he plans to remain in the home for more than five years it is possible that the buyer will pay more for the mortgage over the life of the loan than he would with a simple fixed-rate mortgage. The increase in interest can easily eat up anything he saved during the first five years.
Use Bankrate’s calculator to figure out if an ARM or fixed-rate mortgage will be better for you.
5/1 ARM example
Chemi wants to purchase a home, and she goes to her bank to get a mortgage. Her bank offers her a 5/1 adjustable-rate mortgage with 3.6 percent interest rate for the first five years, then a variable interest rate after that for 25 years. Her bank ties the variable rate to the COFI and adds a margin of 2.9 percent.