Before you lock yourself into a single interest rate for 30 years, you may want to consider an adjustable rate mortgage. One of the most popular types of adjustable rate mortgages is a 5/1. Here’s what you need to know about how this loan works and why it may be beneficial for you:
What Is an Adjustable Rate Mortgage?
An adjustable rate mortgage, or an ARM, is a type of mortgage that has a changing interest rate over the life of the loan. ARMs are also known as variable rate mortgages or even floating mortgages. An ARM consists of an initial rate that remains fixed for a period of time before changing at a set interval.
The adjustable interest rate is generally set by market conditions -- with some limitations. At the end of the day, while an adjustable rate mortgage may sound like a risky venture with unlimited variations, there are terms in place to make it a more stable option for borrowers.
Terms You Need to Know When Dealing With Adjustable Rate Mortgages
Dealing with the world of mortgages as a newbie can definitely be confusing and overwhelming. Trying to figure out all of the terms on your own can seem impossible -- especially when dealing with complex concepts like adjustable rate mortgages. For this reason, it’s worthwhile to cover some of these key terms as it relates to a 5/1 ARM with 2/2/5 caps:
Fixed rate period: Deals with the first number and indicates how long the rate will stay fixed at the beginning of the loan term. In our case, the fixed rate period is five years.
Adjustment intervals: Deals with how often the rate adjusts after the fixed rate period of the loan is over. In our case, the adjustment interval is once a year.
Initial cap: Deals with “capping” how much the interest rate can increase for the initial payment adjustment. While these rates are generally set by market conditions, caps ensure that they don’t rise too quickly. In our case, the initial cap is 2%.
Subsequent adjustment caps: Deals with “capping” how much the interest rate can increase at a time after the initial increase. In our case, the subsequent adjustments are capped at 2%.
Lifetime cap: Deals with “capping” how much the interest rate can increase over the lifetime of the loan. In our case, the lifetime cap of the loan is 5%.
Index margin: Oftentimes, ARMs deal with an interest rate index on top of a fixed percentage. Your index rate is the base rate and the margin is the additional percentage. So if you had a base index rate of 2% and an additional margin of 1%, your final interest rate would be 3%.
What Is a 5/1 Adjustable Rate Mortgage Loan?
Simply knowing these terms should give you a better idea of what a 5/1 ARM is. However, it’s still necessary to dive deeper into this concept to gain a complete understanding.
As you now know, a 5/1 ARM is a mortgage that has an initial five-year fixed interest rate period before switching to a floating interest rate that is adjusted on a yearly basis. The first number “five” refers to the fixed rate period and the second number “one” refers to the adjustment interval.
This type of mortgage loan is quite popular as it provides borrowers with a low initial interest rate before switching to a variable interest rate. In most cases, this can translate into paying higher interest rates over the lifetime of the loan.
Pros and Cons of a 5/1 Adjustable Rate Mortgage Loan?
Like any mortgage, there are both pros and cons to choosing a 5/1 ARM that you need to consider to make the best decision for your unique financial situation.
Some of the pros of a 5/1 ARM include:
Perhaps the biggest pro of a 5/1 ARM is that it starts you out with a relatively low interest rate. This allows you to save money from the beginning that you can use for other home-related things like buying furniture, financing renovations, etc.
When you’re saving money on interest at the beginning of your loan, you also have the option to put that extra money back into your mortgage loan to reduce the principal. When you’re able to reduce the principal quickly, you pay less in interest overall.
This type of mortgage loan is especially beneficial for homebuyers who are looking to stay in their home short-term rather than long-term. If you’re planning on staying in your home for less than five years, then you don’t even have to worry about dealing with higher interest rates down the line and you can simply reap the benefits of lower interest rates now.
Some of the cons of a 5/1 ARM include:
Perhaps the biggest con of a 5/1 ARM is the potential for interest rates to rise. Not only will this increase your monthly payment to cover the additional interest, but you will also pay more on a long-term basis over the life of the loan.
While many people assume that they can easily refinance out of their 5/1 ARM for a fixed rate mortgage before the five-year period is over, you should know that this process comes with associated costs and fees. Additionally, there’s no guarantee that interest rates will be more favorable in the future.
This type of mortgage loan puts you entirely at the mercy of the market that can be quite unpredictable. With a fixed rate mortgage, you’re locked into a single rate and don’t have to worry about interest rates rising. On the other hand, if they fall, you can always refinance into a lower rate. Adjustable rate mortgages give you less security and are riskier if the market takes a turn and interest rates rise.
Other Types of Adjustable Rate Mortgage Loans to Consider
While a 5/1 ARM is one of the most popular choices, there are other types of adjustable rate mortgage loans to consider:
3/1 ARM: Offers an introductory interest rate of three years followed by rates that adjust annually after that.
7/1 ARM: Offers an introductory interest rate of seven years followed by rates that adjust annually after that.
10/1 ARM: Offers an introductory interest rate of ten years followed by rates that adjust annually after that.
5/5 ARM: Offers an introductory interest rate of five years followed by rates that adjust every five years after that.
5/6 ARM: Offers an introductory interest rate of five years followed by rates that adjust every six months after that.
15/15 ARM: Offers an introductory interest rate of 15 years that only adjust once after 15 years, then remain the same for the rest of the loan term of 15 years.
2/28 ARM: Offers an introductory interest rate of 2 years followed by rates that fluctuate for the remaining 28 years of the loan.
3/27 ARM: Offers an introductory interest rate of 3 years followed by rates that fluctuate for the remaining 27 years of the loan.
How to Choose the Right Mortgage Loan and Lender for You
There are several different factors to consider when choosing the right mortgage loan for you. The first thing you should consider is your timeframe. If you’re looking for a forever home, an ARM may not be the best option. On the other hand, if you’re looking to stay in a home on a short-term basis, then an ARM may work well for your situation.
Other factors you should consider are your current financial situation in addition to your planned financial future. If you’re short on cash now and want to take advantage of low interest rates to save money and use it elsewhere, then an ARM may be ideal. However, this is only true if you expect your income to increase enough to cover potential changes in interest rates down the road.
In terms of finding the right lender, not all lenders offer ARMs. As a result, you’ll need to find a lender that offers the products and terms that you’re interested in. But there’s so much more to it than that!
Whether you’re an experienced investor or a first-time homebuyer, you need to look for lenders that offer top-notch customer service. You also need to look for lenders that are totally transparent about their terms. Finally, you need to look for a lender that’s experienced and reputable within the industry.
Final Thoughts on 5/1 Adjustable Rate Mortgage Loans