Homebuying involves a lot of decisions. You choose your neighborhood, your home, your mortgage program and your down payment. But you’ll also need to decide on the structure of your interest rate — fixed or adjustable.
While most people prefer a fixed-rate mortgage, there is a market for adjustable-rate loans. Nearly 7% of all loans originated in April 2019 were adjustable-rate mortgages, according to Ellie Mae’s latest Origination Insight Report.
One common adjustable-rate mortgage is known as a 5/1 ARM. It has an initial fixed rate for five years before the interest rate starts adjusting. The rate can change every year for the remaining life of the loan.
An adjustable-rate mortgage can be a good way to get a better initial interest rate, usually lower than a traditional 30-year fixed-rate loan. But before you dive in to an adjustable-rate mortgage application, you’d better know how the changing interest rate will affect what you pay.
Here’s a guide to how 5/1 ARMs work, how they differ from fixed-rate mortgages and their pros and cons.
What’s a 5/1 ARM?
Before defining a 5/1 ARM, we should first define an adjustable-rate mortgage, or ARM. An ARM is a type of mortgage that has an interest rate that changes, or adjusts, multiple times over the life of the loan.
Different types of adjustable-rate mortgages have interest rates that change at different intervals and are limited to certain levels of increase each time. Most ARMs start out with a fixed interest rate for several years and eventually transition to a period with an variable interest rate for the rest of the term, usually a total of 30 years.
In the case of a 5/1 ARM, the mortgage rate is fixed for the first five years. That’s what the “5” refers to. Then, the mortgage can adjust each year thereafter for the remaining 25 years of the loan term. That’s what the “1” refers to, since the rate changes after one year.
Since the 5/1 ARM is a blend of a fixed-rate and adjustable-rate loan, it can also be known as a hybrid mortgage.
How 5/1 ARM interest rates adjust
Adjustable-rate mortgages are less predictable than fixed-rate loans and are directly impacted by economic factors after you’ve started repaying the loan.
Changes to the interest rate on an adjustable-rate mortgage are based on an index, which is a benchmark interest rate that reflects general market conditions, according to the Consumer Financial Protection Bureau. The most common index used for mortgages is the one-year London Inter-Bank Offer Rate, or LIBOR for short.
Mortgage lenders use the index and then add on a fixed margin to determine your interest rate. A margin is a set number of percentage points added on to the index. So, if the one-year LIBOR is 2.65% and your lender’s margin is 2.15%, your mortgage rate, or “fully indexed rate,” at that time would be 4.8%.
Interest rates on 5/1 ARMs typically start out lower than those for fixed-rate mortgages. As of mid-May 2019, the average 30-year fixed-rate mortgage was 4.07%, while the 5/1 ARM was 3.66%, according to Freddie Mac’s Primary Mortgage Market Survey.
Let’s take a look at how a 5/1 ARM stacks up against a 30-year fixed-rate mortgage after the first five years. We’ll use a hypothetical $250,000 house and assume the buyer is putting down 20%, which means they’ll borrow a $200,000 mortgage.
Interest paid after five years
Principal paid after five years
As shown above, because the 5/1 ARM has a lower interest rate during its fixed-rate period than the 30-year fixed does, the buyer would pay $767.34 less in interest after five years and pay down $217.37 more of the principal balance of the loan. The results could quickly reverse once the 5/1 ARM’s interest rate begins adjusting, however.
Let’s look at the 5/1 ARM (on a $250,000 home with a $50,000 down payment) after two interest rate adjustments to understand how the changes can impact the monthly mortgage payment.
Interest rate (Index + margin)
Monthly payment (Principal and interest)
In the above scenarios, the 5/1 ARM interest rate jumps significantly higher than 3.7%. By the time the rate jumps to 4.8% and again to 4.95%, the monthly payment increases by nearly $130 and $150, respectively.
Pros and cons of 5/1 ARM
As with any financial product, there are benefits and drawbacks. Consider the following pros and cons of borrowing a 5/1 adjustable-rate mortgage.
- ARM interest rates are usually lower than 30-year fixed-rate mortgages (and sometimes 15-year fixed-rate mortgages) for the first five years, which means you’ll pay less in interest during that time.
- Monthly mortgage payments are also typically lower in the first five years, thanks to the lower interest rate.
- There is a limit to how high your interest rate can increase over the life of your loan, which is called a lifetime adjustment cap. The cap is typically five percentage points, but your lender’s cap could be higher, according to the CFPB.
- After the first five years of a 5/1 ARM, the interest rate can adjust each year and is not predictable. Although there’s a cap on how much your rate can increase the first time it adjusts, it can still be significantly higher than the fixed rate you’re losing.
- Because your interest rate adjusts over the life of your loan, so does your monthly mortgage payment. If a higher mortgage payment would greatly impact your budget, this could cause you some affordability problems.
- If you want to keep a fixed interest rate, you must refinance into a fixed-rate mortgage, which comes with closing costs and other fees. You must also qualify for a refinance in order to get out of your existing mortgage.
A 5/1 ARM might work for you if …
“For certain people, like first-time homebuyers, 5/1 ARM mortgages are very useful,” said Doug Crouse, a senior loan officer with nearly 20 years of experience in the mortgage industry.
Homebuyers in the following scenarios could benefit from a 5/1 ARM:
- First-time buyers who plan to move within the first five years of owning their home.
- Buyers who plan to pay of their mortgage very quickly.
- Buyers who are borrowing a jumbo mortgage.
Crouse explained that with some first-time buyers, 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, a real estate agent and community manager for BiggerPockets, an online community of real estate investors, agrees. “You can actually use a 5/1 ARM to your advantage in certain situations,” she said.
A 5/1 ARM could work well for someone who wants to aggressively pay down a mortgage in a short amount of time, Jensen explained. 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?
“The lower initial interest rate frees up more money to make higher principal payments,” Jensen said.
Another group of people that can benefit from 5/1 ARM are those who take out or refinance jumbo mortgages, Crouse added.
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 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.
However, keep in mind that real estate is a risky investment and nothing is guaranteed.
A 5/1 ARM isn’t right for you if …
For homebuyers who plan to stay put for longer than five years, Crouse and Jensen share the sentiment that a 5/1 ARM might not be as beneficial for them.
Homeowners should also consider whether they want to be landlords in the future, Jensen added. If you decide to move out of your home but keep the mortgage and rent out your home, a 5/1 ARM may not serve you.
Additionally, if you think there’s a chance you might not be able to refinance out of a 5/1 ARM by the time your interest rate starts adjusting, you might consider a fixed-rate mortgage instead.
The bottom line
The 5/1 adjustable-rate mortgage can offer you the benefits of a lower interest rate and monthly payment, especially in the first five years of the loan. This alone may make it an attractive product for homebuyers.
Still, you can’t predict how high your interest rate can go when it transitions from fixed to variable, and that’s a budgeting concern you’ll need to consider when weighing your home financing options.
If after reading this guide you think a 5/1 ARM might be right for you, keep this list of questions in mind as you gather mortgage quotes from lenders:
- How long do I want to live in this house?
- Will this house suit my family if my family grows?
- Is there a chance my job will transfer me elsewhere?
- How often does the rate adjust after five years?
- When is the adjusted rate applied to the mortgage?
- If I want to refinance in five years, how much might that cost me?
- How comfortable am I with the uncertainty of a variable rate?
- Do I want to rent out my house if I decide to move?
Once you’ve filled in the answers to the above questions, your next step is to understand the minimum mortgage requirements for the available loan programs.