Is a 5/1 ARM your key to getting a lower mortgage rate?

When you buy a house, you’ll have many types of mortgages to choose from. One of the most popular home loan options is a 5/1 adjustable-rate mortgage, or ARM.

With a 5/1 ARM, you might be able to lock in a low interest rate for the first five years of your loan. But, unlike fixed-interest-rate mortgages, your interest rate can change once that introductory period ends.

• What is a 5/1 ARM?
• How a 5/1 ARM loan works
• Pros and cons of 5/1 ARMs
• How to get a 5/1 ARM

What is a 5/1 ARM?

An ARM, or adjustable-rate mortgage, is a home loan where the interest rate changes periodically throughout your repayment term.

The first number in an ARM represents the initial period, also known as the fixed-rate period, during which your interest rate doesn’t change. The second number in an ARM represents the frequency at which your interest rate will change once the initial period ends.

With a 5/1 ARM, you keep the same interest rate for the first five years. Then, your interest rate changes once per year for the remainder of the loan term.

ARMs usually have repayment terms of 15 or 30 years. So, for example, if you have a 5/1 ARM with a 30-year repayment term, you’ll have a locked-in rate for the first five years, then the rate will adjust every year for the remaining 25 years.

For homeowners, ARMs can offer some stability for the first few years as you get used to budgeting for mortgage payments. You might also consider this type of mortgage if current rates are high, since 5/1 ARMs tend to start with a lower introductory rate than fixed-rate mortgages.

While 5/1 ARMs are one of the most popular variable-rate loan options, you can choose from a number of other types of ARMs, such as a 7/1 ARM or 5/6 ARM.

SHOULD I GET A FIXED-RATE OR ADJUSTABLE-RATE MORTGAGE?

How a 5/1 ARM loan works

A 5/1 ARM functions as a type of hybrid mortgage — that is, it combines the features of a fixed-rate loan and a variable-rate loan. Once the fixed-rate introductory period of your 5/1 ARM ends, your loan rate adjusts once per year based on two numbers: the margin and the index rate.

The index rate follows general market conditions, while the margin is an additional amount your lender adds. Some lenders use a variety of indexes to base mortgage rates on, including:

• Secured Overnight Financing Rate (SOFR)
• One-year constant-maturity Treasury (CMT) securities
• The Cost of Funds Index (COFI)

A fully indexed mortgage rate — the rate you’ll pay when your ARM’s interest rate changes — is a combination of the index rate plus the margin. For example, if the index rate is 4% and the lender adds a margin of 2%, the fully indexed rate for your adjustable-rate mortgage will be 6%.

Interest rate caps

Most ARMs typically follow a rate cap structure. This limits how much your interest rate can rise or fall at different points in the loan term. Rate cap structures consist of three numbers:

• An initial adjustment cap limits how much your rate can increase the first time it changes following the fixed period.
• A periodic adjustment cap limits the amount the interest rate can increase from one adjustment period to the next. For a 5/1 ARM, your rate will adjust once every year.
• A lifetime cap limits the amount the interest rate can increase or decrease over the entire loan repayment term.

So, say your 5/1 ARM has a 2/2/5 rate cap structure. This means your interest rate can’t increase more than two percentage points after the initial five-year fixed period or any subsequent adjustment period. Your interest can also never rise above or dip below five percentage points throughout the life of the loan.

Pros and cons of 5/1 ARMs

If you’re thinking about getting a 5/1 ARM when financing your next home, be sure to carefully compare the pros and cons.

Pros of 5/1 ARMs

• Lower interest rate — You may receive a lower interest rate to start than you would with a fixed-rate mortgage.
• Only one rate adjustment per year — Once the fixed period ends, your 5/1 ARM will only change once a year.
• Potentially lower rates in the future — If interest rates fall, your monthly payment could be lower during those years depending on your lender’s margins and any caps.

Cons of 5/1 ARMs

• Potentially higher rates in the future — Any savings you generate in the earlier years of repayment could be canceled out if payments drastically increase in the future due to rising interest rates.
• More difficult to budget — You might find it harder to budget with an adjustable-rate mortgage since your payment amount will change more often.
• Larger interest expense — If you stick with your 5/1 ARM to the end of the term, you could end up paying more in interest than if you had chosen a fixed-rate mortgage.

REFINANCING REQUIREMENTS FOR A MORTGAGE: WHAT TO KNOW

How to get a 5/1 ARM

Many lenders, banks, and credit unions offer ARMs. Here are some steps you can take to get one:

1. Check your credit. Like with any mortgage, you’ll need to make sure you have a high enough credit score. Check your credit and see which factors are impacting your score, whether it’s debt or high credit utilization. Also, review your full credit report to make sure it doesn’t contain any inaccurate information.
2. Review your income. Lenders will also want to see proof of income and prefer at least a year’s worth of W-2s or two years of tax returns if you’re self-employed.
3. Compare rates for 5/1 ARMs. Next, you’ll want to get prequalified and compare 5/1 ARM rates from different lenders. It wouldn’t hurt to review rates and terms for fixed-rate loans to see if there’s a better deal for you.
4. Get pre-approved. When you find a 5/1 ARM loan that meets your needs, move forward with getting pre-approved and submitting any necessary documents.
5. Review the loan terms. A 5/1 ARM is more complex than a fixed-rate mortgage. Be sure to carefully review the terms to ensure you understand how the loan works, what you’ll need to pay, and when you’ll need to pay.
6. Begin house shopping. Once you’re pre-approved for a 5/1 ARM, you can start looking for homes and completing the rest of your mortgage application details. Continue to ask questions throughout the homebuying process so you can be confident in your decision to get a 5/1 ARM.

A 5/1 ARM doesn’t work for everyone. But if you’re OK with a fluctuating mortgage payment, or you only plan to stay in your home during the initial fixed period, an adjustable-rate mortgage can be a valuable option.

Another reason you might consider a 5/1 ARM is if you expect your income to increase based on your career path and are willing to take on the added risk that comes with a variable-rate mortgage.