A 5/1 ARM is a loan with a fixed rate for the first five years. After that, it has an adjustable rate that changes once each year for the remaining life of the loan. ARM stands for Adjustable Rate Mortgage.
If the interest rate goes up after five years, the borrowers payment could also go up. But if the interest rate goes down after five years, the borrowers payment will most certainly go down.
Homebuyers who take out a 5/1 ARM are essentially taking a view on the future of interest rates. Since interest rates have been steadily coming down since the late 1980s, ARMs have become more and more popular over time compared to 30-year fixed rate mortgages that have higher interest rates.
The Definition Of A 5/1 ARM
Taking out an ARM allows homebuyers to afford more home. But taking out an ARM is also a way for homebuyers to save on mortgage interest for the life of their homeownership.
The average homeownership duration is only about 9 years in America as of 2019. Therefore, it doesn’t make sense to take out a 30-year fixed mortgage for the average homeowner.
You always want to MATCH your fixed rate mortgage portion to the duration you plan to own your home or pay it off.
The change in interest rate once the fixed rate period is over is tied to an index that determines how much your interest rate will rise or fall at each adjustment period.
An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. One common index is the LIBOR index. The LIBOR index also has shorter term and longer term durations as well. It’s up to the bank to choose which index it wants to use to price your loan.
With a 5/1 ARM, the interest rate does not begin changing based on the index immediately. Instead, the interest rate on a 5 year ARM is fixed for the first five years of the loan.
After five years, the interest rate can change annually for the next 25 years until the loan is paid off.
The first number in the name 5/1 ARM indicates the number of years of the fixed period while the second number indicates the adjustment interval. An adjustment interval is the period between potential rate changes (in this case, one year).
Pros and Cons Of An ARM
With a 5/1 ARM, you know exactly what your interest rate will be for the first 5 years. After that, your interest rate, and therefore your monthly payment, could go up or down.
Given we’ve been in a declining or low interest rate environment for over 40 years, the chances are good that your payment won’t go up by much, if at all once the 5-year fixed period is up.
Not only may interest rates stay the same five years from now, your principal balance will have absolutely declined by at least 10%. With a lower principal balance to pay off upon interest rate adjustment, even if interest rates increased a lot, it would be offset by the lower balance.
5/1 ARM Example
Let’s say you are purchasing a $500,000 house and putting down 20 percent. You could borrow $400,000 at a 4.5 percent interest rate at a monthly payment of $2,027.
Alternatively, you could take out a 5/1 ARM for the $400,000 loan and borrow at a 3.5 percent interest rate. Your payment would go down to $1,796 a month, thereby improving your cash flow by $231 a month.
After five years when it’s time for your ARM to adjust, your principal amount will decline to roughly $360,000. Even if your mortgage rate adjusts to 4 percent from 3.5 percent, you’re still paying roughly the same amount in monthly mortgage payments.
Meanwhile, if you had taken out a 30-year fixed loan at 4.5%, you’d be losing compared to the ARM holder even on year six when the ARM holder’s rate adjusts.
Finally, you can always refinance your ARM before the fixed rate period is up, and recast the loan based on a 30 year amortizing term to help reduce your mortgage payments.
Who Should Get An ARM?
I’m a big believer in an adjustable rate mortgage over a 30-year fixed rate mortgage. We are in a permanently lower interest rate environment thanks to technological efficiency, policy efficiency, and greater knowledge of economic cycles.
Further, given the average homeowner lives in their house for nine years, there’s no need to get an ARM longer than a 10/1. Longer fixed duration loans cost more money because the yield curve is generally upward sloping.
Finally, it is not recommended to spend 30 years to pay off your house. If you do, you’ll end up paying an enormous amount of interest on your home. Try to pay off your house within 15 years. You’ll save money and feel great knowing you are mortgage debt free.
If you want to get an ARM, I’d check with Credible. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible from them or your existing bank. Credible allows you to compare multiple real quotes, all in one place for free. When banks compete, you win.
Getting the best mortgage rate is all about making banks compete with one another. Not only should you care about getting the lowest interest rate, you should also pay the lowest refinance or loan fees as well.
About the Author: Sam worked in investing banking for 13 years at GS and CS. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income, most recently helped by real estate crowdfunding. He spends most of his time playing tennis and taking care of his family. Financial Samurai was started in 2009 and is one of the most trusted personal finance sites on the web with over 1.5 million pageviews a month.