You can get a lower monthly payment for the first five years of your loan with this hybrid mortgage. But after the fixed period ends, the interest rate will fluctuate with the market.
Updated May 8, 2020|6 min read
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A 5/1 ARM is a home loan with both a fixed rate and adjustable rate
The 5/1 ARM typically has a lower interest rate during its fixed period (five years) than a fixed-rate mortgage has over its entire loan term
During the adjustment period, the 5/1 ARM rate may increase or decrease and so will your mortgage payment as a result
A 5/1 ARM’s initial low rate can be enticing, but it can be very risky if you aren’t prepared for rising mortgage rates
A 5/1 ARM or adjustable-rate mortgage is a type of mortgage loan that has a fixed- and variable-interest rate period. With a 5/1 ARM, the interest rate is fixed for the first five years of the mortgage (indicated by the “5”), and then the rate adjusts annually (or once a year, indicated by the "1") until the loan is paid off.
If you’re looking for a home loan, you’ll find that the initial interest rate for a 5/1 ARM is usually lower than the interest rate on a 30-year fixed-rate mortgage. It is also possible for the interest rate to further decrease once the fixed-rate period ends, sometimes resulting in even lower monthly payments. The potential savings can make 5/1 ARMs, and other hybrid loans (like a 7/1 ARM), attractive to potential borrowers.
However 5/1 ARMs are risky, as rates can fluctuate based on the economy and other factors outside of your control. Rising interest rates might leave you with a mortgage you can no longer afford. There are some circumstances when you might consider a 5/1 ARM, such as when you plan to sell the house before or refinance within five years, but for most homebuyers, a fixed-rate mortgage is a safer bet in the long run, especially if rates are low to begin with. We’ll discuss the pros and cons of 5/1 ARMs and who might benefit.
A 5/1 ARM is defined by two periods:
The fixed period: For five years, the interest rate will stay the same.
The adjustment period: After five years, the interest rate adjusts annually, based on a market index.
After 60 months of equal monthly payments, you will have your first interest-rate adjustment and the low introductory rate will end. Mortgage lenders set the ARM rate based on financial indexes, which record mortgage rates in general, and add their own margin to the total.
(Learn more about how mortgage interest works.)
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A five-year ARM isn’t the only type of hybrid mortgage. If you have a 7/1 ARM, then the fixed rate lasts for seven years. If you have a 2/28 ARM, it might mean that the start rate lasts for two years and then fluctuates for the remaining 28 years of the loan term. Some lenders may use the numbers to express the rate adjustment period differently, so make sure you fully understand how the loan works.
To protect borrowers from rising interest rates, mortgage lenders restrict how much the interest rate can change during the adjustment period. Rate caps can limit how much the interest rate can increase or decrease.
With periodic rate caps, the lender can set a limit on the initial rate adjustment after the fixed period ends, and even continue to limit rate changes in the subsequent years. The lender can also set a lifetime rate cap to limit how much your interest rate can increase over the entire loan term. Lifetime rate caps are typically required by law.
You can read more in detail about rate caps and how rates are set for adjustable-rate mortgages here.
The most enticing reason for borrowers to choose a 5/1 ARM over a traditional fixed-rate mortgage is the ARM loan's lower interest rate. The introductory period will give you a lower monthly payment, which could save you thousands of dollars during this time.
Having a lower interest rate on your mortgage also means you can pay down more of your loan balance (since amortization happens faster), which ultimately helps you build equity.
The table below compares five years of mortgage payments between a fixed-rate home loan with a 3.9% interest rate and 5/1 ARM loan with an initial rate of 3.0%. The mortgage loan amount is $300,000.
|Mortgage type||Interest rate||Monthly Payment||Total paid after 5 years||Loan balance after 5 years|
In this example, a 5/1 ARM would save a borrower $133 on their monthly payment and almost $8,000 over the first five years of the loan.
If interest rates go down after five years, then your monthly mortgage payment could decrease as well. However, note that, due to the rate cap, your mortgage payment may not actually decrease.
We got these numbers using our mortgage calculator. Check it out to see how much house you can afford.
The biggest risk getting an adjustable-rate mortgage is predicting future rate changes. While it is possible for your interest rate to go down in year six of your 5/1 mortgage, it’s also likely that the ARM rate will go up. Mortgage rates are largely tied to economic factors and forces outside of your control and you may not always be able to predict what’s going to happen.
(Check out today’s mortgage rates and our analysis, updated weekly.)
If interest rates skyrocket and you’re unable to sell the home or refinance it, you could be stuck paying a mortgage you can no longer afford. Even if rates rise only slightly, an unforeseen change in your circumstances, like losing your job, could still make it hard to keep up with mortgage payments, and falling behind could lead to foreclosure.
It’s difficult to justify a 5/1 ARM if interest rates are already low, or if the difference (or spread) between an ARM and a fixed-rate mortgage is low. If the savings are not low enough, then a 5/1 ARM may not be worth the risk of future rate changes.
Instead, borrowers who plan to move out or refinance before five years may be able to benefit from a 5/1 ARM. But keep in mind that there are no guarantees that you will be able to sell the house in five years. The house may lose value as the neighborhood changes or a downturn in the economy might result in a low demand for homes. Of course, it’s possible that the opposite may happen. You can always talk to a real estate agent about the prospects of your local market and a financial advisor about what might be best in your situation.
Similarly, while refinancing can get you out of an ARM, a mortgage refinance means taking out a new mortgage loan to repay the old one. The interest rates at the time of refinance may end up higher than you anticipated, which may make you wish you had taken out a fixed-rate loan at the start. You may also have to pay a few closing costs again, like an origination fee, which might diminish your potential savings if you can’t refinance to a lower rate.
If you plan to pay off the mortgage early and want to make use of the 5/1 ARM’s initial low interest, you may benefit if the mortgage doesn’t have a prepayment penalty.
For many homeowners who plan to stay in the home for many years, a fixed-rate mortgage is a safer bet. If you are looking for lower interest rates, you could buy mortgage points or shorten the loan term (for example, a 15-year fixed-rate mortgage would have lower interest rates). However, the cost of the former will be lumped into closing costs, while the latter may yield a higher monthly payment. The best way to get lower rates is to make sure you’re financially ready when you apply for a mortgage — aim to keep your debt low and your credit score high. You should save enough money for a big down payment, which can directly reduce your loan amount. Making a down payment of at least 20% will also free you from paying mortgage insurance PMI.
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