If you’re like some people, when you hear the mortgage term 5/1 ARM you might say something like, “Ahhhh! Numbers and an acronym—nooooo!!”
Okay, maybe that’s a bit dramatic, but I think it’s fair to say that a 5/1 ARM doesn’t appear to be the friendliest of terms. And that’s really too bad because he’s actually a nice, straightforward guy.
So what is it?
Adjustable-rate mortgages (ARMs) are just that—mortgages with interest rates that adjust depending on market movement. Meaning that if rates go up, your monthly payment will increase, and if they go down, your monthly payment will decrease.
The corresponding numbers tell you how often the rate will change. With a 5/1 ARM, the 5 means that the rate will stay fixed for the first 5 years, and the 1 tells you that it’s subject to change every 1 year after the initial 5.
One of the best things about 5/1 ARMs is that they usually have significantly lower interest rates than fixed-rate mortgages. Not only does the lower rate save you money on your monthly payment, but it also gives you the opportunity to take out a larger loan.
Of course, they do have the potential to adjust to higher levels, whereas fixed-rates stay at the same level for the life of the loan. However, there are ways to take advantage of the low rate without the risk of a rate hike, such as:
- You plan to move within 5 years, therefore the potential rate increase wouldn’t apply to you
- You think your income will have risen to a level where a rate increase would be insignificant
- You want a lower initial monthly payment than is typically offered by fixed-rate mortgages
- You plan on refinancing out of the ARM before the rate gets adjusted to a higher level (can be a risky option because you can never be certain what rates will be like when you want to refinance)
- You have a crystal ball and it says interest rates will go down in the future
It’s not always possible to work the system like the above scenarios. And sometimes the rate environment trumps even the cleverest of schemes. So when you’re evaluating your own situation, it’s almost certainly a bad idea to get a 5/1 ARM if:
- Rates are rising
- You do not expect your income to grow substantially
What you should find out
- Is there a rate cap?
Some loans have a rate cap built into them, which puts a limit on how high the lender can adjust the rate to. It’s good to have because nobody wants to see their rate being adjusted upward for eternity. Although it is a possibility that the cap is set at a level that would still be crippling for most borrowers.
- Is the loan assumable?
If you sell your home, can the buyer take over your existing mortgage at the current rate? Depending on what rates are up to, having an assumable loan can be a good selling point to have.
- Is there a prepayment fee?
Sometimes, you want to pay off your loan early. If there is a prepayment fee, you’ll get charged for paying off your loan before the original agreement.
You’ve got to look at your situation, and ask yourself where you’ll be in 5 years. If you plan on moving or winning the lottery, a 5/1 ARM could be a good call.