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5/1 ARM Loan: What You Should Know

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A 5/1 adjustable-rate mortgage (ARM) loan may be worth considering if you’re looking for a lower monthly payment and don’t plan to stay in your home long. Rates are typically lower than 30-year fixed-rate mortgages for the first five years, which could leave enough room in your monthly budget to afford a new home.

A 5/1 ARM loan comes with risks, though. Understanding how the rate resets after the initial low-rate period ends will help you decide whether the temporarily low payment is worth it.

What is a 5/1 ARM loan?

A 5/1 ARM is a type of adjustable-rate mortgage (ARM) that has a fixed rate for the first five years. After that period, 5/1 ARM rates fluctuate based on your loan terms. A 5/1 ARM may also be called a “hybrid mortgage,” which means it combines a temporary fixed-rate mortgage with an adjustable-rate mortgage.

The “5” in the 5/1 ARM is the number of years your rate is temporarily fixed. The “1” is how often the rate can adjust after the initial fixed-rate period ends — in this case, the “1” represents one year, so the rate adjusts annually.

How does a 5/1 ARM work?

During the initial fixed-rate period, the rate is typically lower. After that, the rate can change based on five factors:

  • The initial adjustment cap. Once the fixed rate expires, the initial adjustment cap limits how much the interest rate can rise. The initial adjustment cap is generally 2% or 5%, meaning the new rate can’t rise by more than two or five percentage points.
  • The adjustment period. Rate changes to an ARM mortgage are based on the adjustment period. For example, a 5/1 ARM will adjust every year after the five-year teaser-rate period ends. Lenders may offer adjustment periods ranging from monthly to every five years.
  • The index. An index is a benchmark variable rate that fluctuates based on market and economic conditions. The margin is added to your index to determine your rate with each adjustment period, and lenders should provide information to illustrate how the chosen index has changed over time.
  • The margin. A margin is a fixed number set by the lender and added to the index to determine your rate when it adjusts.
  • The lifetime cap. Many ARMs have a 5% lifetime cap, which means your rate can never be more than five percentage points higher than the initial rate.
THINGS YOU SHOULD KNOW

Some 5/1 ARM programs may come with an interest-only option, which allows qualified borrowers to pay only the interest due on the loan for a set time, ranging between three and 10 years. This may be a good choice for borrowers trying to save as much money as possible on their monthly payment for a certain period. However, the loan balance isn’t paid down at all, which could result in a big payment jump if the loan isn’t paid off when the interest-only period expires.

When a 5/1 ARM adjusts

To understand when a 5/1 ARM adjusts, you need to understand how each “cap” is disclosed. For example, a 5/1 ARM with 5/2/5 caps means the following:

  • The first “5” is the maximum the interest rate can increase after the temporary fixed period ends
  • The “2” is the maximum the interest rate can adjust during each adjustment period
  • The final “5” is the maximum the interest rate can adjust above the initial rate for the life of the loan

What index is used with a 5/1 ARM?

The index is important to understand because it’s the “moving” part of your adjustable rate. Your lender decides which index will be used. You may hear the term “fully indexed,” which simply refers to how much your rate will be when your margin and index are added together.

Most current ARM programs use the Cost of Funds Index (COFI) or the one-year Constant Maturity Treasury (CMT) securities index. To find out what your fully indexed rate would be, you simply add the current index rate to your margin. For example, if the CMT index rate is currently 2%, and your margin is 5%, then your fully indexed rate would be 7%.

5/1 ARM loan payment example

You’ll receive a 13-page Consumer Handbook on Adjustable-Rate Mortgages (CHARM) disclosure booklet and a loan estimate that details how much your rate and payment can change over time. The booklet may be hard to get through if you’re not familiar with mortgage terminology, so we’ve added an example of how a 5/1 ARM with 2/2/5 caps could adjust if you’re borrowing $300,000 with an initial 4.5% rate.

ARM adjustment periodRateMonthly payment (principal and interest)
Initial five-year fixed rate4.5%$1,520.06
First adjustment cap 
(2 percentage points above the start rate)
6.5%$1,896.20
Lifetime adjustment cap 
(5 percentage points above the start rate)
9.5%$2,522.56

If you don’t refinance to a fixed rate before your ARM resets, you could pay an extra $376.14 per month on your mortgage payment with the first adjustment. In the worst-case scenario, the monthly payment would jump by $1,002.50.

Pros and cons of a 5/1 ARM

Is a 5/1 ARM a good idea? ARM rates may be easier on your wallet at first, but there are longer-term risks. Understanding the advantages and disadvantages of a 5/1 ARM will help you make the most informed decision.

ProsCons
  Your interest rate is lower for the first five years  Your interest rate is likely to rise after the first five years
  Your monthly payment is lower for the first five years  Your payments might become unaffordable after the rate adjusts
  You can use the extra monthly savings to pay your mortgage off faster  Your home’s value could drop, leaving you stuck in an ARM longer than you planned
  You could opt for interest-only payments to save extra money each month  You’ll make less when you sell your home if you choose an interest-only option

Is a 5/1 ARM loan right for you?

Consider a 5/1 ARM if you:

  • Plan to sell or refinance before the adjustable-rate period expires. It may be hard to time a sale exactly with a pending ARM adjustment. Give yourself plenty of lead time to market your home, or make room in your budget for the first payment adjustment.
  • Know your income will grow. If you’re expecting a raise or bonus, you don’t have to worry as much about payment increases.
  • Make more than the minimum down payment. A lower loan amount and monthly payment may soften the impact if you can’t pay off an ARM loan before it adjusts.
  • Can afford the fully indexed payment. In the example above, there’s a $1,000-plus bump in your payment if you end up in an ARM longer than expected. Avoid choosing an ARM if the higher payment would strain your budget.
  • Know the adjustments of the ARM plan you’ve selected. There’s a big difference between a five-year ARM with 2/2/5 caps and one with 5/2/5 caps. Review the CHARM booklet, along with the ARM adjustments on each loan estimate, so you know the worst-case payment scenarios.

How do fixed rates compare to a 5/1 ARM loan?

Most homeowners prefer the stability of a low, 30-year fixed-rate mortgage payment for the life of their loan. However, if current 30-year mortgage rates are too high, a 5/1 ARM rate makes sense — especially if you’re planning to relocate within five years and want to stash the savings from a five-year ARM payment into a moving expense account.

Below is a side-by-side look at the features of a fixed-rate mortgage versus a 5/1 ARM.

Features of a 5/1 ARMFeatures of a fixed-rate mortgage
Payment is typically lower than fixed-rate loans for the first five yearsPayment is higher than 5/1 ARMs during the temporary fixed-rate period
Variable rate could increase after the teaser period endsRate is fixed for the life of the loan

Frequently asked questions

What’s the difference between a 5/1 ARM and a 7/1 ARM?

A 7/1 ARM offers an initial fixed rate for seven years, versus five years with a 5/1 ARM.

What’s the difference between a 7/1 ARM and a 10/1 ARM?

A 10/1 ARM offers an initial fixed rate for 10 years, while a 7/1 ARM comes with a fixed rate for seven years.

How do I qualify for a 5/1 ARM?

Lenders will qualify you based on the maximum rate at the first adjustment or the “fully indexed rate,” whichever is greater. For example, if your initial rate is 4.5% and your first adjustment maximum is 2%, you’d need to qualify for the loan based on a 6.5% interest rate.

How can I get the lowest 5/1 ARM rate?

Some mortgage lenders specialize in ARMs, while others focus their best pricing on 30-year fixed-rate mortgages. Gather mortgage quotes on a comparison rate site from three to five different lenders to find your best 5/1 ARM mortgage rate options.

Do all loan programs offer a 5/1 ARM option?

You’ll find 5/1 ARM loan options with most loan programs, including conventional loans and mortgages backed by the Federal Housing Administration (FHA) and the U.S. Department of Veterans Affairs (VA).

What is a convertible ARM?

Some 5/1 ARM loans offer a “convertibility” option, which allows you to switch to a fixed-rate mortgage before your initial fixed-rate period ends.

 

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