Understanding 5 Year Fixed Mortgage Rates
When most people think of a mortgage, they think of a 15- or 30-year loan. It’s true that most mortgages have terms greater than a decade. In fact, 90 percent of homebuyers choose a 30-year fixed-rate mortgage and six percent chose a 15-year fixed-rate loan. Another two percent of homebuyers choose adjustable-rate mortgages and two percent choose mortgages with other terms. A 5-year fixed mortgage falls into that “other terms” category. In fact, they’re so rare that it’s difficult to find published rates.
Why are long mortgage terms so popular? Well, the shorter the mortgage term, the larger the monthly payment. Few homeowners can afford to pay off a $245,500 home loan (that’s the median sales price of an existing single-family home in the U.S. for the first quarter of 2018, according to the National Association of Realtors) over the course of five or even 10 years.
Still, under the right circumstances, most mortgage lenders will write a mortgage for any length of time the borrower wants. We’ll take a look at some of the reasons borrowers may choose a 5-year mortgage term and how they may help a borrower save a significant amount in interest.
What is a 5-year fixed mortgage?
Many ARMs start at a lower interest rate than FRMs, and that initial rate may be locked in anywhere from a few months to a few years. But once that initial period is up, the interest may go up or down, and the monthly payment will go up or down with it.
When borrowers ask about 5-year fixed-rate mortgages, they might actually be talking about a 5/1 ARM. This mortgage has a fixed rate for the first five years of the 30-year mortgage. After that initial fixed-rate period is up, the interest rate can adjust once each year for the remaining life of the loan.
In the beginning, interest rates on 5/1 ARMs are typically lower than those for 15- or 30-year fixed-rate mortgages. This makes them attractive to borrowers who know they are going to sell or refinance before the 5-year fixed term is up. But most borrowers prefer FRMs because they prefer to know what their monthly payment will be and do not want to take the risk that interest rates will rise, and their mortgage payment will go up over the life of their mortgage.
How do the rates compare with mortgages with longer terms?
The rate you’ll pay on a mortgage is dependent upon many factors, including your credit score, the value of the home, the type of loan you choose and the lender you work with. However, shorter loan terms generally come with lower interest rates.
Again, because 5-year fixed-rate mortgages are so rare, lenders do not publish rates for these loans. However, we can compare the rates for 15- and 30-year fixed-rate mortgages to 5/1 ARMs. According to Freddie Mac, as of July 26, 2018, average rates were as follows:
- 30-year FRM: 4.54%
- 15-year FRM: 4.02%
- 5/1 ARM: 3.87%
Who can benefit from a 5-year mortgage?
If few borrowers can afford to pay off a home in five years, who is choosing these mortgages? In most cases, it’s high-income borrowers who can afford the higher monthly payments that come with a 5-year fixed mortgage. They can dramatically cut the cost of borrowing, pay off their mortgage quickly, build equity faster and save a significant amount of interest.
Even if you can afford a large monthly payment, there may be reasons to consider a longer loan term anyway.
An uncertain future
First, being responsible for such a large amount every month may present some financial challenges down the road. What if you lose your job, develop health issues that make it difficult for you to work or face other unexpected expenses? If your financial situation changes over the next five years, you may find yourself unable to make your mortgage payment.
Second, you may not be able to take advantage of other financial opportunities while you are responsible for a mortgage payment that is much larger than what it would be with a 30-year mortgage term.
For example, say you want to get approved for a mortgage to buy an investment property. One of the factors lenders look at when evaluating your loan application is your debt-to-income ratio (DTI). DTI is all of your monthly debt payments divided by your gross monthly income.
Many lenders will not approve a mortgage for a borrower with a DTI greater than 43%. So even borrowers with excellent credit scores, no credit card debt, a healthy income and lots of equity in their homes could run into trouble getting approved for a loan if they’re responsible for making large monthly payments.
Tougher underwriting standards
For all of the reasons mentioned above, even if a bank is willing to offer a 5-year fixed-rate loan, they will likely hold the borrower to higher underwriting standards than they would for a 30-year loan.
The actual requirements will vary by lender, but they could include larger down payments, lower DTI ratios, higher minimum credit scores and more cash reserves.
Is a 5-year mortgage right for you?
If you are really intent on paying off your mortgage quickly, rather than choosing a five-year loan, you might consider taking a 15-year fixed-rate loan and paying it as if it were a 5-year fixed-rate mortgage.
For example, say you are considering a $250,000 mortgage. The lender is willing to give you a 4.0% interest rate on a 15-year fixed-rate loan. Rather than pay the required minimum monthly payment on the mortgage, you could make additional principal payments to pay the loan off in five years.
|15 years||5 years|
|Monthly principal and interest||$1,849.22||$4,649.22|
|Total interest paid||$82,859.56||$25,963.81|
If you paid an extra $2,800 toward your mortgage’s principal every month, you would be able to pay off the mortgage in just under five years and save a significant amount of interest. But if you ran into financial troubles or wanted to take advantage of other investment opportunities, you’d have the flexibility to do that, too.
There’s one other type of borrower who might be able to benefit from a 5-year FRM: borrowers who have lived in their home for a long time and want to refinance. In this scenario, a 5-year FRM can help a borrower pay off their mortgage balance quickly.
To illustrate, say a borrower purchased a home for 15 years ago using a 30-year fixed rate mortgage with an interest rate of 5.83% (the annual average for a 30-year fixed rate mortgage in 2003). The home is worth $300,000 now, and the mortgage balance is $150,000.
Let’s compare what it would cost the homeowner to continue paying the mortgage for another 15 years at 5.83% versus refinancing to a 5-year fixed-rate mortgage with an interest rate of 3.75%.
|15 years||5 years|
|30-Year FRM||5-Year FRM|
|Monthly principal and interest||$1,252.05||$2,745.59|
|Total interest paid (next 5 years)||$39,324.00||$14,735.26|
|Total interest paid (next 15 years)||$75,368.98||N/A|
By refinancing into a 5-year FRM, the homeowner could own the home outright in five years instead of paying the mortgage for another 15 years and save over $60,600 in interest. And the new monthly payment would be just over double what it would be while continuing to pay a 30-year mortgage.
Paying off a mortgage in five years is not for everyone. But for those who want to build equity quickly, avoid interest rate fluctuations and save a significant amount of interest, a 5-year fixed-rate mortgage can be an attractive option. Just be sure you can afford high monthly payments and have an emergency fund just in case you run into financial challenges or need some extra cash during those five years that you’re making hefty mortgage payments.