5/1 ARM –  What is it and is it a good idea for you?

Choosing the right home loan will help you in the long run. In this post we do a deep dive on 5/1 ARM to help you make the best decision. Let’s get started!

5/1 ARM

While buying a house, many times you are in need of a loan. To ease your understanding, in this article we will be discussing ARM, specifically 5/1 arm – the definitions and how it works. It’s a type of loan which has both fixed and variable interest rates at its disposal.

What is an ARM?

What is an ARM or What does ARM stand for?

ARM stands for Adjustable Rate Mortgage Loan. It is the loan where the interest rate is adjusted based on the market index as per the credit market. There is an initial interest rate that is fixed for a certain adjustment period. The mortgage is governed and regulated by the Federal government. The interest rates are dependent on certain indices like the LIBOR, COFI etc. There are interest-only arms, hybrid arms, convertible arms etc.

Adjustable Rate Mortgage Vs Fixed Rate Mortgage

Here are the key points to understand in adjustable rate mortgage vs fixed rate mortgage loan types. 

• Fixed rate mortgage charges an interest rate that does not change throughout the entire time period of the loan.
• Adjustable rate mortgage charges an initial interest rate which rises as the loan period proceeds further
• Fixed rate mortgage is easier to understand and has less variations whereas adjustable rate mortgage are bit complex to understand and calculate
• Advantage of fixed rate mortgage is that there is protection from any high increase in mortgage payments due to rise in interest rates
• Advantage of adjustable rate mortgage is that it is cheaper at least for the initial 3, 5 or 7 years

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What is a 5/1 arm?

An answer to the question, “What is a 5/1 arm?”

A 5/1 arm is a type of ARM loan which has a fixed interest rate for the first five years. After 5 years, the interest rate is adjustable for the rest of the 5/1 arm loan term. Often the lenders mention caps on the limit of the interest rate increase. It is a rule not to exceed those cap limits while fixing the interest rate. 

5/1 arm rates

While paying off a 5 1 arm in 5 years, you need to understand 5/1 arm rates, and the caps mentioned by the lender. 

What does that cap mean?

For example, 2/2/5 indicates the initial cap as not to exceed 2%, the next adjustments cannot go beyond 2% and on a lifetime the interest cap cannot exceed 5%.

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Most common ARM Intervals

Let us now focus on the most common ARM intervals other than 5/1 arm. The intervals help to understand for how many years an interest rate will remain fixed and the number of adjustments that will be done in the subsequent period of time. Let’s discuss them in details:

3/1 arm interval

When it comes to 3/1 ARM interval, the interest rate remains fixed for the first initial three years of the loan term. And then the adjustment to the interest rate is made at an interval of 1 year for the rest of the term period of the loan.

7/1 arm interval

So, what is a 7/1 arm? In the 7/1 ARM interval, the interest rate remains fixed for the first initial seven years of the loan term. And then the adjustment to the 7-year arm rates is made at an interval of 1 year for the rest of the term period of the loan. 

10/1 arm interval

In the 10/1 ARM interval, the interest rate remains fixed for the first initial ten years of the loan term. And then the adjustment to the interest rate is made at an interval of 1 year for the rest of the term period of the loan.

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What to look for while choosing a 5 1 ARM?

When we have understood about the 5/1 arm loan, let us try to check out: What to look for while choosing a 5 1 ARM?

In the subsequent subsections, we will discuss the salient features of the loan.

1. Periodic rate

Periodic rate is an important parameter for 5 1 ARM loan. It is the interest rate which will be charged as fixed during the initial five years. The rate is decided as per the market indices. It varies at an interval of 1 year by way of adjustment. You need to check out the initial periodic rate while confirming on the 5/1 arm loan, whether it is within your affordable limits.

2. Arm caps

The arm caps help to determine the threshold limit of the interest rates to be adjusted in the subsequent loan time period after the first 5 years. The first initial cap is for the first adjustment interest rate. The next is the threshold for the subsequent adjustments in the interest rate. The last is the threshold to the lifetime interest rate that can be adjusted in the entire loan period.

3. Adjustment intervals

The adjustment intervals help to determine how often the interest rate can be adjusted, basically at which intervals. In 5 1 arm loan, the interest rates are adjusted at intervals of one year as specified by number 1.

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How does a 5/1 arm work?

To understand how does a 5/1 arm work, let us consider a fixed-rate mortgage example.

Loan amount = USD 250,000

Loan period = 30 years

Fixed rate mortgage = 4%

Say, you are availing a 5/1 ARM loan with caps as 2/2/5 and the starting interest rate being 3.5%.

With a fixed rate mortgage, the payment per month is approximately USD 1194. But with ARM, the monthly initial payment comes to USD 1123 approximately. So the monthly savings is USD 71 for the initial 5 years. This will be eventually adjusted in the next year depending on whether your interest rate goes up than what is defined in the cap. You can use a 5/1 arm calculator for the calculations.

Adjustable rate mortgage example

A typical adjustable rate mortgage example using 5/1 arm mortgage calculator is as follows:

Say the loan amount is USD 275000, the initial interest rate is 3.7% and the loan period is 30 years. For the initial first adjustment of 5 years, the monthly payout of principal and interest is USD 1167.65. After 5 years, the payment will vary depending on the interest rate.

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Adjustable rate mortgage pros and cons

In this section, we will discuss adjustable-rate mortgage pros and cons. This will clear the dilemma on whether to opt for fixed rate mortgage or an adjustable-rate mortgage when you avail of a home loan. Let’s focus on the subsequent sections to understand the pros and cons in detail.

What is the advantage of an adjustable-rate mortgage?

The answers to – What is the advantage of an adjustable-rate mortgage?

• Payment is low at the initial few years depending on whether it is 3/1, 5/1 or 7/1 arm rates
• There is flexibility to sell off your home at the end of the fixed period before availing the adjustable payments
• Payments may reduce depending on the caps, the market index and the adjustable interest rates

Why is an adjustable rate mortgage bad?

The answers to – Why is an adjustable-rate mortgage bad? are as follows:

• The calculations, structures, fees and rules are complex and complicated for borrowers to properly understand and follow
• There is a prepayment penalty associated with an ARM. The penalty is the fee charged for either selling or refinancing the loan 
• Difficulty in managing the interest rates and payments and hence the financial planning
• Payments may increase if the interest rates increase

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Fixed rate mortgage pros and cons

Here are the fixed rate mortgage pros and cons.

Pros

• The rate of interest is fixed for the loan period and hence worries are less for variations
• The monthly payments are consistent and hence financial planning is easier
• There is no prepayment penalty charged for selling or refinancing loan

Cons

• The rates may be initially higher compared to adjustable rate mortgage
• Consequently monthly payments may be higher with interest rates being more
• Not very good and efficient for short term homeowners

Is a 5/1 arm a good idea for you?

A common question among borrowers – Is a 5/1 ARM a good idea for you?

5/1 ARM is good for you if the difference in the savings with the fixed rate mortgage loan is good enough. If the initial interest rates are not too low and the monthly payments are not comparatively less, then availing 5/1 ARM loans may not be very beneficial. 

Besides, if you want to sell your house, then check out the prospective selling option within 5 years of the fixed interest rate period. The more you delay, you may not receive the same valuation and sell benefits. Further, there may be fluctuations in the economy leading to lowering of real estate demands.

Interest only arm

Interest only arm is a type of financing arm where the borrower only pays the interest for a certain period of time. The interest is paid monthly and the duration varies from few months to years. No principal needs to be paid at this time period.

Convertible arm

Convertible arm is a type of arm where you have the option to convert it to a fixed rate mortgage loan. But there is a certain period of time after which you can opt for the conversion. You will be charged a certain fee for converting from ARM to fixed rate.