How Does a 5/1 ARM Loan Work?

One of the choices you must make when you take out a loan is choosing between a fixed rate and an adjustable rate. The adjustable rate or ARM, gives you an introductory interest rate with the ability for the rate to adjust in the future.

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In this article, we are going to focus on the 5/1 ARM, however, you can get them in any increment, such as 3/1 and 10/1, for example.

What is the 5 Year ARM?

There’s one thing you will know for certain about the 5-year ARM – it has a fixed rate for five years. After that, it’s anybody’s guess what your new rate will be. The rate may adjust once a year on the same date. So you do have some predictability regarding when the rate will change. Guessing what the rate will be, though, is anyone’s guess.

This is called a hybrid mortgage. It gives you the benefits of a fixed mortgage for the first few years and then turns into an adjustable rate down the road.

Why Take an Adjustable Rate Mortgage?

You might wonder why anyone would be crazy enough to take a mortgage that they have no idea what the interest rate may be. While it seems crazy, there are reasons. Most notably is the lower introductory rate you’ll get. Most ARMs come with a lower than fixed rate interest rate at first. In this case, this means you get the lower interest rate for 5 years. That could add up to significant savings.

In exchange for that benefit, though, you take the risk of getting a higher interest rate when it adjusts. This could give you higher monthly mortgage payments for which you need to be prepared to pay. You can watch the index that your loan is tied to go get an idea of what your rate might do, but until that actual adjustment date, you don’t know what it will be for sure.

The Adjustment Periods

The 5/1 ARM only adjusts one time per year. Your closing documents will tell you when that adjustment date is each year. It will also tell you the index and margin. These are important terms to know.

The index is chosen by the lender. It’s what they use for your ‘base rate.’ This is the unpredictable part of an adjustable rate mortgage. If you follow U.S. securities and the LIBOR, you might have an idea of what the index might do. Knowing which index your loan is tied to can help you know what to expect.

The margin is the amount the lender chooses to add to the index. For example, if your margin is 2%, the lender will add 2% to whatever the index is on the date of your rate adjustment.

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The Maximum Adjustments

There is some good news, though. There are maximum adjustments or caps that the lender must set for your loan. There are the:

  • Initial adjustment cap – This is the maximum amount the interest rate can adjust for the first adjustment. Typically, this cap is 2% or 5%, but a lender can make it whatever rate they see fit.
  • Period cap – This is the maximum amount the interest rate can change for future adjustments, excluding the first one.
  • Lifetime cap – This is the most the interest rate can increase over the life of the loan. If the rate hits the lifetime cap before the end of the term, it cannot ever get any higher.

The good thing about the caps is that you are able to plan for the ‘worst case scenario.’ This way you know the highest your payment might get. This number can help you determine if you think the payment is one you can afford. It doesn’t mean you will ever get to that point, but preparing yourself just in case is important.

The Benefits of the 5/1 ARM

While the 5/1 ARM may sound risky, it definitely has its benefits, they include:

  • More purchasing power – A lower interest rate could help you be able to afford a higher mortgage amount. This is important if your debt ratio is close to the maximum allowed for the program. The lower rate can help you stay within the parameters and get approved.
  • Save money – The lower introductory rate can help you save money on interest during the first five years. If you are still in the home after that, the rate will adjust, but the savings on the lower initial rate helps you save on the total interest paid over the life of the loan.
  • Big savings if you move – If you know your home purchase is for the short-term, you can take advantage of the savings of the lower interest rate. If you sell before the rate adjusts, you come out ahead of the deal, making a greater return on your investment when you sell.

The 5/1 ARM should be entered with caution, though. It is a great loan program, but only when you understand the full ramifications of it. Make sure you know the full payment and how it will affect your finances. Once you are sure you can afford it, take advantage of the lower interest rate. If things go your way, you might even be able to refinance out of the adjustable rate before the rate adjusts.

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JMcHood

Justin McHood is a managing partner at Suited Connector and has been recognized by national media outlets as a financial expert for more than a decade.

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