Finding the right mortgage can be a confusing process, especially for first-time homebuyers. There are so many options that it can be hard for a consumer to know how to get the optimal rate and terms.
One way to get a better initial interest rate is by taking out a 5/1 ARM mortgage. Small wonder that many potential borrowers want to know what makes a 5/1 ARM mortgage so unique and whether it might be the right loan for them.
Below is a guide to how 5/1 ARM mortgages work, how they are different from traditional 15- and 30-year mortgages, and what pros and cons consumers need to understand.
How a 5/1 ARM works
A 5/1 ARM mortgage, as explained by MagnifyMoney’s parent company, LendingTree, is a type of adjustable-rate mortgage (hence, the ARM part) that begins with a fixed interest rate for the first five years. Then, once that time has elapsed, the interest rate becomes variable. A variable rate means your interest rate can change. Consequently, so can your payment.
The number “5” in “5/1 ARM” means that your interest rate is fixed for five years. The number “1” in “5/1 ARM” means your interest rate could change each year after the first five years have passed.
Interest rates are based on an index, which is a benchmark rate used by lenders to set their rates. An index is based on broad market conditions and investment returns in the U.S.. Thus, your bank can adjust its interest rates at any point that the benchmark rate changes or if there are major fluctuations in the U.S. stock market.
What’s fixed? What’s adjustable?
Fixed-rate mortgages have the same interest rate for the duration of the mortgage loan. The most common loan periods for these are 15- and 30-year.
Because a 15-year fixed rate mortgage is, obviously, for a shorter term than a 30-year fixed rate mortgage, you will likely pay much less interest over time. However, as a result, you will have a higher monthly mortgage payment since the loan payoff period is condensed to 15 years.
Adjustable-rate mortgages like the 5/1 ARM loan mentioned above have a fixed interest rate for the beginning of the loan and then a variable rate after the initial fixed-rate period.
The chart below shows an example of the same house with three different types of mortgages.
As you can see below, the 15-year fixed rate mortgage has a lower interest rate, but a much higher payment. The 5/1 ARM has the lowest interest rate of all, but once that interest rate becomes variable, the lower rate is not guaranteed. This is one of the cons of a 5/1 ARM mortgage, which will be outlined in the next section.
Here is an example of three different types of mortgage payments for someone taking out a $200,000 mortgage. The chart below makes the assumption that the fictional person this is for has a high credit score and qualifies for good interest rates.
Total Interest Cost
The pros and cons of 5/1 ARM mortgages
The biggest advantage of a 5/1 ARM mortgage is that interest rates are typically lower for the first five years of the loan than they would be with a typical 15- or 30-year fixed-rate deal. This allows the homeowner to put more of the monthly payment toward the principal balance on the home, which is a good way to gain equity in the property.
The 5/1 ARM mortgage commonly has a lifetime adjustment cap, which means that even though the rate is variable, it can never go higher than that cap. That way, your lender can tell you what your highest monthly payment will be in the future should your interest rate ever reach that point.
As mentioned above, the con of a 5/1 ARM mortgage is the whole “adjustable” component. Once you get past the five-year term, there will be uncertainty. Every year after the fifth year of your mortgage, the rate can adjust and keep adjusting.
There is a way around this. You can refinance your mortgage after the five years and secure a new mortgage with a fixed rate. But be warned: Refinancing comes with fees. You will have to calculate on your own whether or not the savings you derive from a lower payment for five years is worthwhile as you measure it against the cost of refinancing to a fixed-rate loan.
That’s why it’s important to know how long you want to live in your home and whether or not you’ll want to sell your home when you move (as opposed to, say, renting it out).
A 5/1 mortgage is right for …
“For certain people, like first-time homebuyers, 5/1 ARM mortgages are very useful,” Doug Crouse, a senior loan officer with nearly 20 years of experience in the mortgage industry, tells MagnifyMoney.
Here are the types of people who could benefit from a 5/1 ARM mortgage:
- First-time homebuyers who are planning to move within five years.
- Borrowers who will pay off their mortgages very quickly.
- Borrowers who take out a jumbo mortgage.
Crouse explains that with some first-time homebuyers, the plan is to move after a few years. This group can benefit from lower interest rates and lower monthly payments during those early years, before the fixed rate changes to a variable rate.
Mindy Jensen, who is the community manager for BiggerPockets, an 800,000-person online community of real estate investors, agrees. “You can actually use a 5/1 ARM to your advantage in certain situations,” Jensen tells MagnifyMoney.
For example, Jensen mentions a 5/1 ARM could work well for someone who wants to pay down a mortgage very, very quickly. After all, if you know you’re going to pay off your loan early, why pay more interest to your lender than you have to?
“Homeowners who are looking to make very aggressive payments in order to be mortgage-free can use the 5/1 ARM” to their advantage, she explains. “The lower initial interest rate frees up more money to make higher principal payments.”
Another group that can benefit from 5/1 ARM mortgages, Crouse says, is those who take out or refinance jumbo mortgages.
For these loans, a 5/1 ARM makes the first few years of mortgage payments lower because of the lower interest rate. This, in turn, means that the initial payments will be much more affordable for these higher-end properties.
Plus, if buyers purchased these more expensive homes in desirable areas where home prices are projected to rise quickly, it’s possible the value of their home could soar in the first few years while they make lower payments. Then, they can sell after five years and hopefully make a profit. Keep in mind that real estate is a risky investment and nothing is guaranteed.
The 5/1 isn’t right for …
Long-term home buyers who plan to stay put for the long haul probably won’t benefit from a 5/1 ARM loan, experts say. “An adjustable-rate mortgage loan is a bad idea for anyone who sees their home as a long-term choice,” Jensen says.
Crouse echoes the sentiment: “If someone plans to stay in their home for longer than five years, this might not be the best option for them.”
Jensen adds that homeowners should consider whether or not they want to be landlords in the future. If you decide to move out of your home but keep the mortgage and rent a property, it won’t be so beneficial to sign up for a 5/1 ARM loan.
Questions to ask yourself
If, after reading this guide, you think a 5/1 ARM mortgage might be right to you, go through this list of questions to be sure. Remember, you can also consult with your lender.
- How long do I want to live in this home?
- Will this home suit my family if my family grows?
- Is there a chance I could get transferred with my job?
- How often does the rate adjust after five years?
- When is the adjusted rate applied to the mortgage?
- If I want to refinance after five years, what is the typical cost of a refinance?
- How comfortable am I with the uncertainty of a variable rate?
- Do I want to rent my house if I decide to move?
Hopefully these questions and this guide can aid you in reaching a sensible decision.
The post The 5/1 ARM Mortgage: What Is It and Is It for Me? appeared first on MagnifyMoney.