Have you ever wondered what the difference is between a 5/1 ARM and a 5/5 ARM or a 7/1 ARM and a 7/6 ARM and so forth? Let me explain in this article because the difference adds to another dilemma mortgage borrowers should consider.
An adjustable-rate mortgage (ARM) is a home loan with an introductory fixed interest rate upfront, followed by a rate adjustment after that initial period. The introductory fixed interest rate period is signified by the first digit, i.e. 5-year fixed-rate period for a 5/1 ARM.
The fixed-rate period after the initial introductory period is over is signified by the second digit, i.e. 1-year fixed-rate period for the new rate for a 5/1 ARM.
The primary difference between a 5/1 and 5/5 ARM is that the 5/1 ARM adjusts every year after the five-year lock period is over. Whereas a 5/5 ARM adjusts every five years.
Given we know ARMs make up only a tiny portion of total loans, ARMs with an adjustment fixed-rate period of more than one year are even more rare. But let's discuss anyway.
The Most Common ARM Fixed-Rate Durations
An ARM generally has a lower mortgage rate than a 30-year fixed-rate mortgage because it is on the shorter end of the yield curve. As a result, more people will likely take out ARMs as mortgage rates go higher.
In a 3/1 ARM, the initial fixed interest rate period is three years. In the more common 5/1 ARM, the initial fixed interest rate period is five years. Personally, I have a 7/1 ARM with an initial fixed-rate period of seven years.
Then there is the 10/1 ARM with an initial fixed-rate period of ten years. 10/1 ARMs are not as common because they start encroaching on the 15-year fixed-rate mortgage, which tends to have very competitive rates.
Please note there are also 7/6 ARMs and 10/6 ARMs! The 6 represents six months, not six years. In other words, after the introductory rate period is over, the new mortgage interest rate will adjust every six months.
Choosing The Type Of ARM Based On The Yield Curve
When I took out my 7/1 ARM in 1H 2020, 7/1 ARMs provided the best combination of the lowest rate with the longest initial fixed-rate period because the yield curve was kinked at the 5-7-year mark.
See the yield curve below two months before I locked in my 7/1 ARM at 2.125% with no fees. The interest rates for a 7/1 ARM were actually slightly lower than the interest rates for a 5/1 ARM. Therefore, I decided to go the 7/1 ARM route for two more years of interest rate stability. After all, I had purchased our “forever home.”
Before you take out an ARM, take a look at the latest yield curve. Identify if there are any dips in the yield curve and decide whether that fixed-rate duration is something you are comfortable with. The duration where there is a dip is where you will get the best value.
5/1 ARM or 5/5 ARM?
The biggest difference between the 5/1 and 5/5 ARM is there are more regular interest-rate adjustments on the 5/1 loan, i.e. every year versus every five years. Therefore, if the mortgage rates and costs to get the mortgage are equal, then it is better to get a 5/5 ARM than a 5/1 ARM.
However, there is no free lunch when it comes to getting a mortgage. Even no-cost refinances have costs. The cost is just in the form of a higher mortgage rate you have to pay.
It is easier for banks to do no-cost refinances or new no-cost mortgages on bigger mortgage balances. There is a bigger spread to cover costs and make a larger profit.
A 5/5 ARM usually has a slightly higher interest rate than a 5/1 ARM. Therefore, you have to decide and know the following:
- How much is the peace of mind of four more years of a fixed-rate adjustment period worth
- The most the interest rate can jump during each adjustment period (initial and subsequent adjustment cap)
- The lifetime mortgage interest rate cap on the 5/1 and 5/5 ARM
- Where you think interest rates will be after the introductory fixed-rate period is over (hard to know!)
- The margin charged and index used. Margin + index = fully indexed interest rate, or adjustable interest rate.
Once you know these factors, you can then make a more informed decision.
5/1 ARM Versus 5/5 ARM Example
A Financial Samurai reader commented,
I closed on a purchase in February with a 5/5 ARM at 1.875%. The margin is 2% and the adjustment cap is 2%. The index is the 5-year Treasury yield. The lifetime maximum rate is 6.875%.
Therefore, the maximum interest rate from years 6-10 would be 3.875%. The other ARM I considered was a 5/1 with 2.5% margin and a lifetime maximum rate of 7.875%. The index would have been the one-year Treasury. Adjustment cap is also 2%.
I’d like to think I made the better choice with the 5/5 vs. the 5/1. Maybe when the rate resets, the difference between the 5-year and 1-year yield would be less than 0.5%? What do you think?
(The bank almost made a mistake at the closing table and almost gave me a 5/1 ARM with the 5/5 terms (2% margin on a 5/1 instead of 2.5%). That may have been a bank error in my favor!)
I think the reader made a great choice in taking out a 5/5 ARM instead of a 5/1 ARM.
First of all, paying a lower margin is better. The margin is the profit the bank makes off you. Second of all, currently, rates are going up more on the short end compared to the long end. The 5/5 ARM's index is off the 5-year Treasury yield whereas the 5/1 ARM's index is based on the one-year Treasury yield.
Finally, the certainty of having to pay a maximum of 3.875% from years 6-10 is comforting. Even if the 5/5 ARM adjusts by the maximum 2%, the combined 10-year mortgage rate average is only 2.875%.
No Wonder 30-Year Fixed-Rate Mortgages Are More Popular
Based on this example above, it's easy to see why most mortgages are 30-year fixed-rate mortgages.
Despite higher mortgage rates and a fixed-rate duration far longer than the average homeownership tenure, 30-year fixed mortgages are easier to understand. And the better you understand something, the more confident you are in going that direction.
But if your goal is to increase the probability of saving the most amount of mortgage interest as possible, you will naturally learn everything there is to know about an ARM. As a result, you may end up saving yourself hundreds of thousands of dollars!
When To Get A 5/1 ARM Or A 5/5 ARM
In a rising interest rate environment, a 5/5 ARM is usually more attractive. A 5/5 ARM borrower benefits from delayed adjustments when rates rise. The more rapid interest rates are rising after the introductory fixed-rate period is over, the more attractive ARMs are with a longer reset duration of one year.
In a declining interest rate environment, a 5/1 ARM is usually more attractive. As rates decline, the 5/1 ARM borrower can more easily benefit. The more rapidly rates decline after the introductory fixed-rate period is over, the more attractive a 3/1 ARM, 5/1 ARM, 7/1 ARM, and 10/1 ARM become.
Just know that it's hard to predict the future of mortgage rates within 12-24 months, let alone 3-10 years. Therefore, in general, it's best to get the lowest mortgage interest rate possible with the lowest fees. A bird in the hand is better than two in the sky.
Related: The Biggest Downside Of Paying Off Your Mortgage Early
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As an FYI: the 5/5 ARM product is found mostly at credit unions, particularly the larger ones. It started at credit unions with a military field of membership, since the 5 year term worked well with military deployment terms, or so I have been told.
Nowadays most of those credit unions have multiple ways of joining or community fields of membership. Just Google “5/5/ ARM” and “credit union”. Pentagon Federal Credit Union offers it and anyone can join it as a good example.
Thanks for all the great information on ARMs Sam! Every financial news/info outlet seemed to only ever talk about 15 or 30 year fixed, like ARMs don’t exist.
I recently came across a loan I haven’t seen the likes of before. My partner is getting a job at a University of California school and they have their own mortgage origination program (the UC MOP). The loan has been at 3.25% for a long time. It is a “1/1” if you will, where it adjusts every year from the get go, but the maximum increase is only 1% per year. It seems like they offer it as a perk to attract faculty and include it with their other short term investments: “The Standard MOP Rate is the most recently available four-quarter average earnings rate of the University of California’s Short-Term Investment Pool (STIP), plus an administrative fee of 0.25%, subject to the applicable minimum interest rate.” So it is a little less coupled from the average mortgage rates from banks or mortgage lenders. They also have a 5/1 (which is at a low 3.75% right now), but after the initial 5 year term it can increase up to 5%, with 1% caps afterward.
The interest rate has been so low on the “1/1” and the long run terms seem less favorable for the 5/1, I’m more inclined to do that one year. Do you know of anyone who has done these “UC loans”? What are your thoughts?
Thanks!
Hi Matt, don’t know anybody with a 1/1. These type of mortgages are more common in Singapore where more mortgage rates are variable rates.
The 1/1 has worked well over the decades if you can get one. However, resetting this year and next year will be more costly.
For 5/1s and longer, what often happens is rates may go up during the intro period, but then back down before the reset.
Oh how fascinating! All these years I’ve had a mortgage and refinanced and I never heard of a 5/5 ARM before, let alone a 7/6 or 10/6 ARM. Thanks for listing out those five bullet points for helping to decide between different AMRs. I’ll definitely be coming back to this post next time I refinance! Thanks!