What is a 5/1 ARM?

What Is A 5/1 ARM?

A 5/1 ARM is one example of an adjustable-rate mortgage (ARM), which gives you a fixed rate of interest for 5 years, after which your mortgage interest rate will be adjusted every year for the rest of the life of your mortgage.

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To understand a 5/1 ARM (sometimes called a 5 1 Arm), it is helpful to understand the overall concept of ARMs, how they work, and the pros and cons of those types of loans.

What Are Adjustable-Rate Mortgages (ARMs) And How Do They Work?

Unlike traditional fixed-rate mortgages (where the interest rate of your loan stays the same throughout the life of your loan), adjustable-rate mortgages are loans where the interest rate is fixed for a certain number of years, then adjusts based on current interest rates for the rest of the life of the loan.

People like them because they are usually less expensive (they have a lower interest rate) than a traditional fixed-rate mortgage, and ARMs can actually be a better option in certain situations (see below.)

The names given to adjustable-rate mortgages tell you some of the conditions of that loan. 

The first number shows the number of years the interest rate will remain fixed. This is frequently called the introductory period. In a 5/1 ARM, the 5 indicates that your introductory period interest rate won’t change for 5 years. The second number is how frequently the interest rate will be adjusted after that. In a 5/1 ARM, the interest rate will automatically be adjusted every 1 year based on the prevailing interest rates at that time.

5/1 ARMs are not the only type of adjustable-rate mortgages. Lenders offer all kinds of different loans, including a 3/1 ARM, a 7/1 ARM, a 10/1 ARM, a 7/6 ARM, a 10/6 ARM, a 5/5 ARM, etc. 

Just remember: the first number is how long in years the interest rate is fixed initially, and the second is how frequently it adjusts after that.

But it’s not quite as simple as that. There are three other factors that are important when considering which and whether an adjustable-rate mortgage is right for you. These are usually shown in the cap numbers that follow the type of ARM being offered. 

For example, you may see a 5/1 ARM with 2/2/5 caps. These numbers are your protection in a worst-case scenario where interest rates go way up after you have received your loan. Here’s what those numbers mean:

The Initial Cap

The initial cap is the first cap number in the 2/2/5. It indicates the maximum amount your interest rate can increase after the introductory period is over.

In this case, that number is a 2, meaning that at the end of the 5-year introductory period, the most your interest rate could increase would be two percentage points. Even if interest rates spiked after you secured your loan, your interest rate in year six wouldn’t be higher than your  introductory rate) plus 2%, the initial cap rate.

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Let’s say that your introductory rate was 6.1%. The maximum interest rate you could be charged in year six would be 6.1% + 2% = 8.1%

But that doesn’t mean that your interest rate will increase to 8.1%, the maximum to which it could increase. If prevailing interest rates at that time were 6.8%, your interest rate in year 6 would be 6.8%, not 8.1%. And they could even go down if the interest rate at the end of your initial 5 years was below your introductory rate.

Caps On Subsequent Adjustments

Your cap on subsequent adjustments (each time the is reviewed for interest rate adjustment) is the second number in the 2/2/5 example shown above. In this case of a 5/1 ARM, the most your interest rate could increase by in any year after the first adjustment year, would be an additional 2 percentage points.

This protects you from huge increases in your mortgage interest rate in any interest rate adjustment.  

Lifetime Cap

The lifetime cap is the third number in the 2/2/5 example shown above. It indicates the maximum amount your interest rate could increase over your introductory period rate over the life of your loan.

In this case, your loan could increase by a maximum of 5 percentage points. If your initial interest rate was 6.1%, your loan could never go above 11.1% even if interest rates skyrocketed during the life of your loan to even higher rates than that.

Your Interest Rate Could Also Decrease

It’s important to realize that these caps are upward limits only. If prevailing interest rates decrease, your interest rate could also decrease whenever your interest rate adjustment dates happen, which in a 5/1 ARM, would be once a year after the first 5-year period.

Why You May Want To Consider An Adjustable-Rate Mortgage: The Pros of ARMs

Because ARMs usually have a lower interest rate than a traditional fixed-rate mortgage, (oftentimes charging an interest rate that’s 0.2 to a full percentage point lower than a fixed-rate mortgage depending on the type of ARM, and the current interest rate environment) they are something that should be considered.

But, ARMs aren’t for everyone. Here are some situations where it may be wise to consider them: 

ARMs may be a good idea if you believe that interest rates will be decreasing in the next several years and will stay down for an extended period

An ARM could be a way to capitalize on the prospect of lower interest rates in the future because you’ll start with a lower interest rate, then your future adjustments will occur at the lower rates you anticipate seeing in the market.

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Of course, you may be wrong, in which case it would have been better to lock in a fixed-rate mortgage, preventing your mortgage from rising if interest rates increase, then, if rates fall, you can refinance your mortgage to lock in those lower interest rates.

ARMs may be a good idea if you don’t plan to remain in your home for more than a few years

Many people purchase homes, knowing they will almost certainly be moving to another home within the next few years because they’ll need a bigger home for their growing family, their company will likely move them to another location, they are likely to receive big salary increases in the future and will want to upgrade, etc.

If you’re confident that will be true in your case, an ARM may be a way to purchase your home at an interest-rate discount, knowing you will move out of this home before the introductory period is over.

ARMs may be a good idea if you plan on pre-paying the principal on your mortgage

One strategy some people use is to take the difference between what they would have paid for a fixed-rate mortgage and their ARM and apply that to their mortgage principal, thus paying off their mortgage more quickly and saving tens of thousands in interest.

For example, let’s say your monthly mortgage payment would be $1,500 for a fixed-rate mortgage and $1,425 for an ARM. You may want to consider getting the ARM but still making the $1,500 payment each month, applying that extra $75 to your principal amount. This way there’s no immediate savings, but over the life of your loan, you will save thousands to tens of thousands in interest by doing so. 

And, if your mortgage rates increase, your new payment will be based on a lower principal amount. While that generally won’t make up the difference, it will help.

The Cons of ARMs

Of course, there are always disadvantages you should consider.

You will likely end up paying a higher house payment during the life of your ARM mortgage

While you hope interest rates will remain the same or decrease, there are no guarantees. You should assume that your loan will adjust to a higher interest rate, possibly all the way to the caps built into your loan over time.

Of course, you can always refinance your mortgage if interest rates increase drastically, but realize that each time you do so, you’ll end up paying closing costs.

You will likely end up paying more interest in total over the life of your ARM loan

Because it’s likely that interest rates will increase, there’s a probability that you will pay more in interest over the life of your loan than you will with a standard fixed-rate loan.

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Your assumptions about your living situation could change

Right now you could be saying “oh, we’ll definitely be moving in the next 2-3 years, so we’ll just take the lower interest rate now.” That may be true, but you never know how your life will change over time and things may be looking considerably different for you several years from now.

Frequently Asked Questions About 5/1 ARMs

What Is A Convertible 5/1 ARM?

Some ARM loans come with a conversion option, allowing you to change your ARM to a fixed-rate mortgage at some time in the future. The specifics of when you can make that change and the conditions and costs to do so will be cited in your loan contract. This is a nice option if you can get it because it reduces the risk of the changes associated with a 5/1 ARM.

What Is A Hybrid Loan And How Does It Apply To A 5/1 ARM?

ARMs are oftentimes referred to as hybrid loans because they behave like a fixed-rate loan during the introductory period, then like an ARM loan after that. During the introductory period (the first number in your loan – with a 5/1 ARM it is 5 years) you have almost no risk due to interest rate fluctuations. Once that period is finished, you are then totally at risk of interest rate fluctuations, within the caps established in your loan.

Which Is Better, A 5/1 ARM, Or A 10/6 ARM?

Great question, since you can replace the 10/6 ARM number with any different type of ARM. 

If you assume that the interest rate will be the same between those two mortgage options (which won’t be the case, a 10/6 ARM is going to charge a higher interest rate than a 5/1 ARM), in a world where interest rates are rising:

• Bigger first numbers (longer ARM introductory periods) tend to be better than smaller ones because they lock your loan in for longer periods before the rates can be adjusted. So a 10/6 would be better than a 5/1 in this case.
• Bigger second numbers (the length of time between adjustments) tend to be better than smaller ones because they increase the time between interest rate adjustments. (Again, a 10/6 ARM would be better than a 5/1 ARM in a rising interest rate environment.)

Of course, in a world where interest rates are falling, the exact opposite is true. Shorter periods are better so you are not stuck at the higher rates for longer than you have to be. Of course, you always have the option of refinancing your mortgage (though refinancing is not free, you’ll still need to pay closing costs), so it’s probably better to assume that bigger numbers (longer time periods between adjustments to your rate) are better as a rule.

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What Is A 5/1 ARM Interest-Only Loan

They’re tough to find, but if you can get them, interest-only loans mean that you only pay interest (no principal) on your loan for a certain amount of time. After that, your payment will jump because you will also have to make payments towards reducing your principal. We don’t recommend this type of loan in most cases, and they’re hard to find in the marketplace.

Can You Pay Off A 5/1 ARM Early?

Generally yes, many mortgages in today’s environment allow prepayment of the principal amount without incurring a penalty. You should definitely ask this question of your lender to make sure it applies to your specific loan.

What Percentage Of Mortgages Are Adjustable Rate?

In the low-interest-rate environment that existed for many years, there weren’t many advantages to having an ARM, so the added risk didn’t make sense. Only about 4% of loans during that period were ARMs.

However, in the changing interest-rate situation beginning in 2022, more people are more seriously considering using an ARM to finance their homes.

Does the FHA Offer A 5/1 ARM?

The FHA does allow for a 5/1 ARM offering with a cap of 1% increase annually and 5% over the life of the loan or 2% increase annually and 6% over the life of the loan. Shop around if you are considering this option to secure an FHA loan with the lower caps.

Bottom Line, Is A 5/1 ARM A Good Idea?

It could be, depending on your assumptions of what will happen with interest rates, the amount of time you plan to live in your home, the conditions of your specific loan, and your personal risk tolerance.

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