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Is a 5/5 ARM the Mortgage Loan for You?

5/5 arm

The 5/5 ARM is a hybrid adjustable-rate mortgage. That means it blends some of the best aspects of fixed- and adjustable-rate mortgages — but it blends some of the worst aspects, too.

Depending on your situation, a 5/5 ARM could be an amazing mortgage that combines low costs with minimal risk. But it could lead to unsustainably high mortgage payments. We cover everything you need to know to decide whether the 5/5 ARM should be your next mortgage.

What is a 5/5 ARM?

A 5/5 ARM is an adjustable-rate mortgage that borrowers pay off in 30 years. The interest rate on a 5/5 ARM stays the same for the first 60 months (five years) of the loan, and after that, the interest rate could go up or down every five years. In general, rates on 5/5 ARMs adjust on the basis of an index (like the 1-year Constant Maturity Treasury), plus a margin (say 2.5%). If the index moves up 2%, your interest rate will move up 2% at the five-year mark. The interest rate could also change at the 10-year mark, 15-year mark and so on.

Like most adjustable-rate mortgages, most 5/5 ARMs have a lifetime maximum interest rate. Usually, rates cannot increase more than 5 percent to 6 percent, but the exact cap varies by lender. Consider a 5/5 ARM at an initial interest rate of 4.5% with a maximum adjustment of 5% — the highest rate the bank will ever charge on this loan will be 9.5%.

Most 5/5 ARMs also offer periodic adjustment caps. These limit the amount that the interest rate can adjust upwards. For example, a 5/5 ARM may have a 2% periodic adjustment cap. If your initial interest rate was 4.5%, the rate cannot increase to more than 6.5% at the five-year mark. Debbie Ames Naylor, executive vice president and president of mortgage banking at PenFed Credit Union, explained that the periodic adjustment cap is one of the biggest advantages of the 5/5 ARM compared with other ARMs.

“We’re in a rising rate environment, so mortgage rates might go up. With a 5/5 ARM you might see rates go up by a maximum of 2%, but that’s all the increase you’ll face for the next five years,” Ames Naylor told LendingTree. “When you take out a 5/5 ARM you have 10 years of payments with no more than a 2% increase. It’s possible to come out ahead compared to a 30-year mortgage over a 10-year horizon.”

Of course, a 5/5 ARM doesn’t only adjust upwards. If interest rates fall, borrowers with a 5/5 ARM will get the opportunity to lock in the lower rate for another five years. According to Ames Naylor, PenFed customers who took out 5/5 ARMs when PenFed first released them in 2007 actually saw their rates go down at adjustment in 2012.

Caleb Cook, vice president of mortgage lending at Digital Federal Credit Union (DCU), clarified that rates on 5/5 ARMs can decrease, but they will never fall below a specified margin amount. For example, if the bank prices the 5/5 ARM off of an index, plus a margin of 2.75%, the rate on the 5/5 ARM will never fall below 2.75%.

The 5/5 ARM offers somewhat lower initial interest rates than 30 year fixed-rate mortgages, but the interest rate may increase over time. Despite the risk of rising interest rates, 5/5 ARMs offer some protections that other adjustable rate-mortgages do not. For example, borrowers don’t need to worry about interest rates (and payments) increasing every year. Instead, payments adjust just once every five years. Since it’s impossible to predict exactly how the index will move, homeowners who take out a 5/5 ARM need to prepare for a worst-case scenario. In many cases, that means planning to see a 2% rate increase every five years until the homeowner moves or refinances.

How is 5/5 ARM different than a 5/1 ARM?

Like a 5/5 ARM, a 5/1 ARM is an adjustable rate mortgage where the first adjustment comes after five years. Both 5/5 ARMs and 5/1 ARMs have 30-year payoff schedules, lifetime adjustment caps, and sometimes periodic adjustment caps too. However, the two loans have some important differences, including:

5/1 ARMs can adjust every year: During the first 60 months, the interest rate and monthly payment on a 5/1 ARM remains fixed. After that, interest rates and monthly payments change as often as every year. Borrowers may see their monthly payment go up year after year for the 25 years remaining in the loan. By comparison, payments on a 5/5 ARM can change every five years.

5/1 ARMs have lower initial interest rates: Compared to a 5/5 ARM, most 5/1 ARMs offer lower initial interest rates. Lenders tend to offer lower initial rates on 5/1 ARMs because they can increase rates faster on 5/1 ARMs compared to 5/5 ARMs. This lower rate on 5/1 ARMs means that homeowners enjoy a lower payment the first five years of the loan. The 5/1 ARM also yields big savings potential if you expect to live in a house for less than five years, provided there is no prepayment penalty.

May have servicing differences: Since 5/5 ARMs are still a niche mortgage product, many lenders hold them in their portfolio and service the loans themselves.

By comparison, lenders are more likely to sell 5/1 ARMs and 7/1 ARMs, which means the servicing institution may change. These changes present a small hassle for borrowers who may need to change their bill pay settings or create login information at a new bank. However, borrowers shouldn’t count on a lender holding onto a 5/5 ARM indefinitely. Even though many lenders service the loans themselves right now, they may eventually sell the loans.

Pros and cons of 5/5 ARMs
Pros Cons
Lower initial rates compared to 30 year fixed: In general, borrowers will find lower rates on 5/5 ARMs compared to fixed interest rates on 30-year loans. Depending on how long you stay in the house, the lower initial rate may mean you pay less in interest costs over the life of the loan, even if rates move up. Initial rate higher than 5/1 or 7/1 mortgage: The 5/5 ARM has higher rates than ARMs that adjust annually (such as the 5/1 or 7/1 ARM). Borrowers who plan to live in a house under a decade may save more money by choosing an ARM with annual adjustments.
Five years between adjustments: When interest rates increase, borrowers can expect the rates on a 5/5 ARM to increase, too. However, borrowers always have five years to prepare for any change in their monthly payment.

“The biggest thing borrowers need to consider is how the interest rate and payment that could change at a reset,” Ames Naylor told LendingTree. “With a 5/1 or 7/1 ARM, you may see payments increase every year. If you think you’re going to be in the house for more than 5 years, I would typically choose the 5/5 over another adjustable rate mortgage.”

Payments may increase: Fixed rate mortgages offer the security of a fixed payment over the life of a loan, but adjustable rate mortgages offer no such guarantee. With a 5/5 ARM, payments may increase possibly by hundreds of dollars per month over the life of the loan. (The exact dollar value of increase depends on the initial size of the mortgage and the interest rate cap).
Qualify for a larger mortgage with the same income: The lower interest rate on a 5/5 ARM means that borrowers have lower initial payments (compared with 30-year fixed rate mortgages). This means that borrowers could qualify for a larger mortgage with the same income. As Cook told LendingTree, “The 5/5 ARM offers more buying power with less interest rate risk. It tends to be a good choice for people who plan to change jobs, move up houses or who only want to stay in a specific school district until their kids graduate.” Possible prepayment penalty: The Board of Governors of the Federal Reserve warns that some adjustable rate mortgages carry prepayment penalties if you pay off the mortgage in the first three to five years. Lenders must disclose prepayment penalties, so be sure to check if you think you’ll stay in a house for less than five years.
Payments may decrease: It’s impossible to predict future mortgage rate changes. But, if rates decrease, the rate on a 5/5 ARM will decrease, too. A lower interest rate translates to a lower monthly payment for at least five years. No conversion options: Most 5/5 ARMs do not offer borrowers the opportunity to convert a loan to a fixed-rate option. That means that borrowers who fear rising interest rates will have to pay for the expense of a refinance if they want to move to a fixed-rate option.
Periodic adjustment caps: Most 5/5 ARMs feature periodic adjustment caps, which mean your mortgage rate cannot increase by more than a set amount each adjustment period. If you have a 2% adjustment cap, the first 10 years of the ARM will always be within 2% of the initial interest rate.

Can you convert a 5/5 ARM to a conventional fixed-rate mortgage?

Some adjustable rate mortgages allow borrowers to “convert” a loan to a fixed rate options when the rate adjusts (or when the borrower chooses). Borrowers can exercise the option to lock in a rate if they are nervous that the interest rate may increase even further. Right now, the conversion option isn’t available for most 5/5 ARMs. And although you could try to negotiate for a conversion option, most lenders are unlikely to put it into the loan.

That doesn’t mean that people taking out 5/5 ARMs will be stuck with the same loan forever. If you decide to take out a 5/5 ARM, you can refinance it to a fixed rate mortgage at any time. However, Cook warned that whenever you refinance a 5/5 ARM, “You’ll still pay the prevailing interest rate, and you’ll probably pay thousands in refinancing costs. In a lot of cases, refinancing [a 5/5 ARM] isn’t worth it.”

Refinancing to a fixed rate only makes sense if you’ll stay in the house long enough to enjoy the financial benefits of refinancing. Since 5/5 ARMs only adjust once every five years, you may need to stay in the house a decade or more for the savings to pay off.

Should you choose a 5/5 ARM for your next mortgage?

The 5/5 ARM is something of a hybrid between a fixed-rate mortgage and an adjustable-rate mortgage with annual increases. It offers lower initial monthly payments, and borrowers get a full five years to prepare for every potential payment increase. As Cook explained, “A 5/5 ARM can really help you make a ton of headway on paying down the principal value of the loan during the first five years if you’re willing to put extra money towards the loan.”

But people looking to pay down their mortgage quickly aren’t the only people who can benefit from a 5/5 ARM. The 5/5 ARM ideal for homebuyers that expect to see substantial increases in their income over the next five years. By opting for a 5/5 ARM, borrowers qualify for a larger mortgage now. Their increased income will allow them to repay the mortgage if rates increase in five years. On the other hand, people with fixed incomes or who expect a drop in income should opt for fixed-rate mortgages instead.

The 5/5 ARM also makes a lot of sense for borrowers who expect to stay in a house less than a decade. The 5/5 ARM presents a lower payment-change risk than a 5/1 ARM or a 7/1 ARM, but still offers lower initial rates than a 30-year fixed rate mortgage. However, borrowers who plan to stay in their house for longer than a decade will probably prefer the security of a fixed-rate mortgage.


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