Future Homeowner’s Guide to the 5/1 ARM
If you’ve started looking for a home, there’s a good chance that you’ve heard about the 5/1 adjustable-rate mortgage (ARM). Though adjustable-rate mortgages were once the bane of Realtors and homeowners across the country, the loans have slowly started coming back en vogue. Just because they’re becoming a bit trendier these days doesn’t mean that you should run out and get one without knowing what you’re getting into, of course.
Depending on who you ask, 5/1 ARMs are either one of the best loan products on the market or a huge risk that you should avoid at all costs. The truth is somewhere in between. The 5/1 ARM can be a good loan for your new home, but it also carries some risk if you aren’t careful.
To figure out whether a 5/1 ARM is right for your needs, it’s important to find out more about what they are and how they work. Once you know that, you can weigh the pros and cons of the loan and determine whether it can help you make your dreams of home ownership come true.
Understanding the 5/1 ARM
The 5/1 ARM is what is known as a hybrid mortgage, featuring both a period with a fixed interest rate and a longer adjustable-rate period. In the case of the 5/1 ARM, the fixed-rate period lasts for the first five years of the loan. Once the five-year fixed period ends, the loan then enters an adjustable-rate period that can experience changes in its interest rate every year.
During the fixed-rate period, the interest rate is relatively low and doesn’t change for that entire time period. This results in smaller payments during the initial term of your loan, saving you money and making it easier to establish a good payment history during the early years of your home ownership. This is especially useful for first-time homeowners, since it establishes a positive payment habit that can carry on into the adjustable-rate period of the loan.
Once the adjustable-rate period kicks in, the interest rate can change by 1% to 2% per year depending on the terms of your loan. But your specific loan may have an interest rate cap—for example, a maximum of 5% for the lifetime of the loan. ARMs with shorter fixed terms are typically capped at 1% per year and 5% overall, while longer-termed loans feature 2% and 6% caps.
Benefits of a 5/1 ARM
You may have heard some bad things about the 5/1 ARM, but there are actually several potential benefits to this loan type. Though the specific advantages may vary based on the terms of your loan, here are the most common ones:
The low interest rate during the fixed-rate period keeps your payments low for the first several years of your loan. Not only does this keep interest from building up, but it also gives you a chance to make additional payments to reduce your principal before higher interest rates kick in.
The interest caps on your loan during the adjustable period keep your interest rate from growing too quickly or increasing indefinitely. This is especially important if your adjustment occurs during a period when interest rates are high; the cap on your loan can keep your interest rate lower than other rates in the market.
If interest rates are low, then the adjustments on your loan can actually reduce your payments further. Because your interest rate is adjusted according to market rates, drops in interest rates can bring your payments down as well.
Drawbacks of a 5/1 ARM
Many consider the 5/1 ARM a risky loan, in large part because of the potential drawbacks that come with it. Most of these risks are associated with the adjustable-rate period on the loan, since that is where the largest variance in the loan occurs. These disadvantages are also somewhat dependent on the specific terms of your loan, but here are a few of the most common ones you might encounter:
While a 5% to 6% increase in your interest rate may not seem excessively high, when that’s applied to a large principal then you can see a significant increase in the amount you have to pay.
Your monthly payment can increase significantly over the course of a few years if interest rates continue to rise. This can be especially troublesome near the beginning of your adjustable-rate period, since you’ll be used to paying a smaller amount each month.
You may not be able to refinance your loan once the adjustable-rate period starts. Some homeowners make plans to refinance after the fixed-rate period ends, but the terms of your loan may make it difficult to find a lender willing to refinance.
Some loans may have additional fees or other penalties that kick in if you attempt to sell your home or refinance the loan before a certain period of time has passed.
Because of the different interest rates and changing terms involved, 5/1 ARMs can be fairly complex. This may make it difficult to understand what’s going on with your loan if you try to look up the details later.
When to Get a 5/1 ARM
In general, the best time to get a 5/1 ARM is when you can take advantage of the loan’s benefits while avoiding its drawbacks. Your first goal should be trying to get your fixed interest rate as low as possible.
There are a few ways you can go about this. As with any loan, take some time to build up your credit score to try to get the best possible rate during your fixed-rate period. Be sure to check interest rates and rate forecasts to see if rate changes are predicted in the near future as well. While this isn’t possible if you’re looking to close on a loan soon, if you have a more open time frame, you may be able to save quite a bit on your loan simply by timing it right.
Another option to help you find a lower rate is to look into programs such as FHA insurance from the U.S. Department of Housing and Urban Development. If you qualify for an FHA loan, then you will usually get a lower interest rate and need a smaller down payment, and you may get more favorable loan terms in general. FHA-insured loans are available only through FHA-approved lenders, but several different loan types—including the 5/1 ARM—can be FHA-insured.
Once you’ve found the lowest fixed rate on your ARM, you need to start making plans to try to avoid the potential downsides of your loan. Many homeowners do this by selling the home they buy or refinancing their loan around five years after taking out the 5/1 ARM. While this may seem extreme, you have to consider that the average homeowner owns their first home for only around seven years. Of course, it’s important that you also find out in advance whether there will be any fees or other charges associated with selling or refinancing.
Do You Need a 5/1 ARM?
With all this in mind, it’s time to ask yourself a question. Is an ARM, or the 5/1 ARM specifically, the loan that will help you get the house you want?
That depends. If you’re looking for a home to live in for a few years before moving on to bigger and better things, then the 5/1 ARM could be a great way to get the lowest possible interest rate on your mortgage during the time you own the home. But if you plan on getting a mortgage for a longer-term stay, then the 5/1 ARM might be a riskier option.
That’s not to say that you can’t get an ARM even if you plan on staying in a home for the long term. You just need to make sure that you plan ahead since you’ll have the instability of the adjustable-rate period looming in your future. You can make plans to refinance, you can pay down your principal during the fixed-rate period, you can build your savings to provide a buffer against payment increases, or you can do all of these to ensure that you’re covered no matter what happens.
If you are looking for a long-term home, keep in mind that other mortgage products might be a better fit than the 5/1 ARM. A 30-year fixed-rate mortgage might not have as low of an interest rate as the rate during the fixed period of an ARM (depending on the terms of your loan), but it also won’t have the risk that’s commonly associated with ARMs.
Other loans, including shorter-termed mortgages, could also be a better match. Regardless of the loan you choose, though, you can take pride in knowing that you’re realizing your dreams of home ownership.