Is a 5/5 ARM the Mortgage Loan for You?
If a 30-year fixed rate mortgage and an adjustable rate mortgage had a baby, it would be a hybrid ARM — a loan with an interest rate that’s fixed for an introductory period before morphing into an adjustable rate. Mortgages that adjust are complex financial creatures we usually identify by two characteristics: First, how long the introductory or “start” period lasts and then what happens next.
The result is that we get ARMs with shorthand descriptions such as the 3/1 ARM, 5/1 ARM, 7/1 ARM and the 10/1 ARM.
What these terms mean is that the ARM start period has a given length, say three years, five years, seven years or 10 years. The second number — the “1” — means that the loan then adjusts every year.
But what if we structured ARMs differently? Why not dump the annual rate change and instead have an ARM with an interest level that changes less frequently?
This brings us to the 5/5 ARM mortgage loan, an adjustable-rate mortgage where — you guessed it — the interest rate changes every 5 years.
The attraction of the 5/5 ARM is that borrowers can lock-in a today’s rate for at least 60 months — a rate which is less than the rate being charged for 30-year fixed-rate financing. Considering that many borrowers move or refinance in less than 1035 years the 5/5 product may represent financing at discount when compared with a fixed-rate option.
In looking at 5/5 ARMs, borrowers should examine several major factors:
5/5 ARM Mortgage Loan Interest Rates
The interest rate for an ARM is determined by the combination of an index which moves up and down during the life of the loan — such as the interest paid by Treasury Securities, the LIBOR rate or the 11th District Cost of Funds Index (COFI) . A margin is added to the index. The margin is a number which never changes and represents the lender’s markup. As an example, if the index is 1.8 percent and the margin is 2.0 percent then the interest rate is 3.8 percent.
Keep in mind that your mortgage rate might not always equal the index plus margin (which is called the fully-indexed rate). Your mortgage rate is also constrained by caps and floors, which limit how much a rate can adjust at one time, and how high or low the rate can be during the lifetime of the loan. If your index equals 6.5 percent and your margin equals 2.0 percent, the fully-indexed rate might be 8.5 percent, but if your loan has a lifetime cap of 8.0 percent, your interest rate won’t exceed 8.0 percent.
How Long Does the Start Rate Last?
ARMs come with an initial rate which is lower than that of a fixed-rate loan. The reason for the lower initial interest rate is that ARMs are a little safer for lenders than fixed-rate loans — lenders won’t be stuck getting 4.3 percent from borrowers when their costs have risen to ten percent. However, no borrower would choose an ARM unless there was a significant benefit for him or her. That’s why lenders offer the benefit of an interest rate that’s lower than that of fixed-rate loans — to entice borrowers into choosing the ARM.
Be sure you understand both the length and terms of the start rate as well as the possibly-higher monthly payments that might occur with an adjustment.
What Are the Adjustment Caps?
ARMs are set up so that they have two and sometimes three rate caps, say 3.0 percent for the first adjustment, 2.0 percent with each adjustment thereafter and not more than 6.0 percent over the life of the loan. Lenders often express such as cap arrangement as 3/2/6. Another approach is to just have two caps — a per adjustment cap and a life time cap, say 2/6. The rates change up or down with the movement of the independent index. Borrowers should look at the rate caps with care because, for example, if the first adjustment can change by 6 percent then potentially that initial interest change can lead to a huge payment increase.
Is There a Conversion Feature?
Some ARMs have a conversion feature which allows the borrower to covert the ARM to fixed-rate financing. The terms for such features vary but, as one example, it may be possible to convert from an ARM to a fixed-rate loan at then-current mortgage rates plus .25 percent.
The features above are all negotiable and depend on your credit standing and the availability of funding in the marketplace. As always, for the best rates and terms be sure to shop around.