What Is A 5/1 ARM, And Is It Right For You?
What Is A 5 Year ARM Loan?
ARM is an abbreviation for an Adjustable Rate Mortgage. The 5-year ARM loan is a little different. For the first five years of the loan, you have a fixed interest rate, so no variation in your payments. At the end of 5 years, it switches to an ARM loan, which means your interest rate will change once each year to reflect current market rates. Of course, this means your payment amounts will change each year, too.
You will probably see a 5-year ARM called a 5/1 ARM on many financing sites and in real estate news. It is a type of hybrid mortgage combining the consistency of a fixed rate mortgage and the potential cost savings of an adjustable rate mortgage (ARM). Your loan starts off as a fixed rate mortgage for the first 5 years, then at the 5-year mark switches automatically to an ARM loan. Your mortgage company will notify you each year, after the 5 years, of changes to your interest rates and how it affects your payments.
What You Need To Know About A 5/1 ARM
The most important thing you must understand is how an ARM or adjustable rate mortgage works. It has an interest rate that will fluctuate with the market. Your interest rate will be updated each year on the anniversary of the loan. Why would you choose an ARM loan? Almost always, an ARM has a lower initial interest rate than a fixed rate mortgage. The loan institutions are protected from rising interest rates, and you take on the risk that your interest rate will rise. If the interest rates rise, your payments rise with it. Of course, if interest rates fall, your payments decrease, also.
How Does The Loan Company Determine My Interest Rate?
Your interest rate will be determined using an index, which can be based on the current prime interest rate, the Federal Funds Rate, U.S. Treasury Securities and several other factors. Your bank, or mortgage company, will notify you of the changes in rates. The rates vary according to economic factors in the country and around the world.
The 5/1 ARM gives you the advantage of not changing for the first 5 years. Once the loan passes the 5-year mark, it works like a standard ARM loan. Your interest rate will change whenever an adjustment date occurs, which on a 5/1 ARM is annual. If you have a 30-year 5/1 ARM, your interest rate could change up to 25 times before you finish paying off the loan. You may notice there are 7/1 ARM loans available, too. The first number indicates how many years for the fixed interest rate. The second number, in this case, 1, indicates your interest rate will change once per year once the fixed rate period ends.
What Are Benefits And Dangers Of A 5/1 ARM?
A hybrid mortgage offers a lower interest rate than a fixed loan but a higher interest rate than a standard ARM. It gives you the security of knowing what your payments will be for the fixed period of your loan. With a 5/1 ARM, you know exactly what your interest rate will be for the first 5 years. Your monthly payments will be variable after the five years, which could mean your payments will increase.
The number one benefit is lower interest rates at the start of your loan. A hybrid mortgage will have a lower rate than a fixed rate mortgage, but slightly higher rates than an ARM loan. You get to have the security of fixed payments for the first 5 years. You could see payments decrease if interest rates decline, but more commonly, your interest rates will rise in the future.
Let’s take a look at an example. If you need a $300,000 loan for the home you want to buy, on a fixed rate mortgage your interest rate might be 5.5%. This would result in a monthly payment of $1703. The 5/1 ARM has a rate of 4.75%, dropping your payments down to $1565 per month. That is almost $150 per month in savings during the first five years of your loan.
This is when the risk begins. At the end of 5 years, your loan rate will be adjusted to reflect current market rates. If the rates have climbed significantly over the last 5 years, your payments could jump quickly. Most likely, you will see a modest increase in your interest rates and a slight increase in your payments. Make sure you ask if the loan you are considering has a payment cap. The payment cap provides you with the maximum interest rate your loan can climb to.
Many home buyers choose a 5/1 ARM because they plan to refinance their loan before the 5 years is up. Always ask your lender if there will be any penalties if you choose to refinance your home before the 5 years expires. This will help you make an informed decision on whether a 5/1 ARM is right for you.
Is A 5/1 ARM The Right Choice For You?
This depends on your situation. If you need the stability of a fixed rate mortgage, plus the lower rates of an ARM loan, a 5/1 ARM could be ideal. Sit down with your lender and ask them to figure your loan costs for a 30 year fixed loan compared to the 5/1 ARM. Ask them to discuss any added fees and interest caps for the 5/1 ARM. Once you have all the facts, you can make a confident decision if the 5/1 ARM is the right decision, or not.