How a 5/1 ARM Loan Works: Advantages & Disadvantages

July 28, 2014 | By Brandon Cornett | © 2019, QualifiedMortgage.org | Our copyright policy

When shopping for a mortgage loan, you will eventually have to choose between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM). Both products have certain pros and cons associated with them. Additionally, there are different sub-categories within these two top-level categories.

This article focuses on the 5/1 ARM loan in particular. This product is also referred to as the “5-year ARM,” for reasons that will soon become clear. It is the most popular adjustable mortgage product in use today. In this tutorial, you will learn how a 5/1 ARM works, the advantages it can offer in the short term, and the potential disadvantages over the long term.

How the 5/1 ARM Loan Works

A fixed-rate home loan carries the same interest rate for the entire repayment term. As a result, the borrower’s monthly payments also stay the same. The 30-year fixed-rate mortgage (FRM) is by far the most popular type of financing used by home buyers today.

An adjustable mortgage, on the other hand, has an interest rate that will eventually start to change or “adjust” on a recurring basis. There are several different types of ARM loans available to borrowers. The primary difference between them is (A) the length of the initial fixed-rate period, and (B) the frequency of adjustments after the initial period has expired.

Most lenders today offer “hybrid” adjustable loans, and the 5/1 ARM is a good example. They are called hybrids because they start off like a fixed-rate mortgage, before switching into an adjustable product. They are not purely one or the other, but a little of both.

Here’s how the 5/1 hybrid ARM loan works:

This type of mortgage starts off with a fixed interest rate for the first five years. That’s what the number ‘5’ designates in the label. During this initial phase, the loan essentially behaves like a fixed-rate product. The interest rate stays the same, and so do the monthly payments. So there is some degree of stability with these products, at least initially.

After the first five years, however, the interest rate will begin to adjust or change. The rate changes annually, or every one year. That’s what the number ‘1’ designates in the label. So the 5/1 designation tells you this loan has a fixed rate for a period of five years, after which it will adjust every one year.

That’s how the 5-year ARM works, in a nutshell. Let’s move on to talk about the possible advantages and disadvantages.

Advantage: Lower Rates During the Initial Phase

One of the benefits of using a 5/1 ARM is that it offers a lower rate during the initial phase, when compared to a standard 30-year fixed-rate mortgage product.

For example, if you refer to the Primary Mortgage Market Survey (PMMS) on Freddie Mac’s website, you will see the average interest rates for the current week across four categories: 30-year fixed, 15-year fixed, 5/1 ARM, and 1-year ARM. You’ll also notice that the average rates assigned to the 5-year ARM are lower than the 30-year mortgage rates. They’re usually more than a full percentage point, or 100 basis points, lower than the FRM.

So that’s the primary advantage of using a 5/1 adjustable loan. It offers a more attractive interest rate during the first five years of the repayment term, when compared to the “standard” 30-year option. That’s the main reason why borrowers choose this product.

But there’s a potential downside as well, especially if you keep the loan beyond the first adjustment.

Disadvantage: Uncertainty Over the Long Term

Due to their adjustable nature, 5-year ARM loans are more unpredictable over the long-term.

You’ll know exactly what your interest rate will be for the first five years (it will show up in the “Good Faith Estimate” form you receive from the lender). You’ll also know that it won’t change during that time. So your monthly payments will remain static. But you won’t know exactly how the interest rate will behave over the long term. This is the primary disadvantage of the 5/1 ARM product.

Most adjustable-rate mortgages are associated with a particular index. These indexes are usually the interest rates banks charge when loaning money amongst themselves. For example, 5/1 ARM loans are frequently “attached” to the London Interbank Offered Rate (LIBOR). The Cost of Funds Index (COFI) is another commonly used index. When the indexes go up or down, the ARM loans associated with them will follow suit.

Is an Adjustable Mortgage Right for You?

Let’s recap. How does a 5/1 ARM work? This hybrid product starts off with a fixed interest rate for the first five years of the repayment term. After that, the rate will begin to adjust every year for the remainder of the term — or until the home is refinanced or sold.

When does it make sense to use a 5/1 ARM loan? To answer this question, you must think about your long-term plans and how comfortable you are with risk.

  • How long do you plan to stay in the home? If you’re planning to stay for many years, you might be better off using a fixed-rate mortgage that offers long-term payment stability.
  • On the other hand, if you only plan to keep the mortgage for a few years before either selling or refinancing the home, you might benefit from using a 5/1 ARM loan with an initially lower interest rate.

The key to all of this is to think about the long-term. Can you accept the uncertainty and risks associated with an adjustable mortgage? What would happen if you couldn’t sell or refinance the loan after five years? How much bigger might your payments become? Could you afford the new payments if they went up by, say, $50, $100 or $200 per month?

Here’s a good rule of thumb: If you are stretching your budget to the limit during the initial five years of the loan, it might become totally unaffordable beyond the first five years.

The Importance of Rate Caps

We’ve covered the basics of how a 5/1 ARM loan works. Lastly, we need to talk about caps. They are an important component to understand.

These days, nearly all adjustable-rate mortgages have caps that limit how much the interest rate can rise. There are two main types:

  • Periodic caps limit how much the interest rate can rise from one adjustment period to the next.
  • Lifetime caps limit the rate increase over the entire life of the loan.

According to the Federal Reserve:

“With an adjustable-rate mortgage, your future monthly payment is uncertain. Some types of ARMs put a ceiling on your payment increase or interest-rate increase from one period to the next. Virtually all types must put a ceiling on rate increases over the life of the loan.”

As a borrower, you need to understand the caps that are assigned to your particular loan. You also need to think about what would happen to you, financially speaking, if the interest rate rose by the maximum amount allowed from one adjustment to the next. Could you afford the monthly payments at that higher level? If not, you are taking on a risky loan and might need to reconsider.

Disclaimer: This article explains how a 5/1, or 5-year, ARM loan works. Despite the length of this tutorial, we have only scratched the surface of adjustable mortgages and their pros and cons. This article is meant to give you a general understanding of how these products work. It serves as a springboard for your continued research. To learn more about this topic, refer to the Federal Reserve’s “Consumer Handbook on Adjustable Rate Mortgages,” which is available online.