If you’re a prospective homebuyer considering an adjustable-rate mortgage, you’re probably wading through a sea of different numbers: 5/1, 10/6, 7/1, 10/1, 7/6 and more. Adjustable-rate mortgages are less common and more complicated than fixed-rate mortgages, but they have one major advantage right now. The introductory rate is lower than the rate for the most common type of home loan, 30-year fixed-rate mortgages.
But that doesn’t mean a 5/1 ARM is the best option for you. Read on to find out if the schedule and costs attached to this type of home loan match your needs.
How does a 5/1 ARM work?
To understand the basics of a 5/1 ARM, let’s look at the numbers. The “5” represents the introductory period, meaning your initial rate will stay the same for the first five years from your closing date, and the “1” represents how frequently your rate will change, meaning every year. For example, if you take out a 5/1 ARM with a rate of 6.7% in December, that’s the interest rate you’ll have over the next 60 months until your rate and payment begin to change on an annual basis.
After the five-year introductory period, the rate can go up or down, based on broader economic indicators, though there are limitations on how much the rate can increase. An ARM has periodic caps that restrict the amount it can go up in one year, and a lifetime cap that dictates how much it can increase over the entire loan term.
What happens when a 5/1 ARM rate adjusts?
According to the Consumer Financial Protection Bureau, you’ll receive a notification approximately seven to eight months before your first rate adjustment and an estimate of your new monthly payment. In subsequent years, you’ll receive a similar notification a bit closer to the adjustment, somewhere between two and four months before it kicks in.
What index is used for a 5/1 ARM?
If you don’t work in finance, you probably aren’t thinking much about the indexes that lenders use for adjusting the rates on a 5/1 ARM, such as the Secured Overnight Financing Rate and the One-Year Treasury Constant Maturity. Lenders use that index, plus a margin, to set your rate. For example, if the Secured Overnight Financing Rate stood at 5.3% and your lender’s margin was 2.25%, your rate would be 7.55%.
How does a 5/1 ARM compare to a fixed-rate mortgage?
A 5/1 ARM will typically have a lower rate and a lower monthly payment for the first five years compared with a 30-year fixed-rate mortgage. A 5/1 ARM can look more appealing to homebuyers because the introductory payments create extra room in your budget.
Pros and cons of a 5/1 ARM
If you’re considering a 5/1 ARM, here’s a rundown of the main upsides and downsides:
Potential for a decrease in your interest rate: There’s no rule that rates are going to rise. Economic conditions could lead to a drop in your rate at some point during the adjustment period, creating a nice surprise for your budget.
More confusion: When you review mortgage documents, you’re going to look at a maze of terms and dates. With ARMs, you’re going to look at a lot more complicated information about indexes, rate caps and margins. If you don’t work in finance, these could make your head spin.
Should you get a 5/1 ARM?
If you’re trying to figure out if you should apply for a 5/1 ARM, consider three big questions:
- How long are you planning to stay in the home? If you’re confident you’re going to sell the home in a relatively short period of time, a 5/1 ARM can be a great decision. For example, if you plan to sell within the first five years, you’ll never need to worry about a rate adjustment. However, plans can also change. According to research from the National Association of Realtors, the median expected time in a home for first-time homebuyers is 18 years.
- Will you be able to refinance into a fixed-rate mortgage in the future? There’s no crystal ball for mortgage rates, so this one has no clear answer. However, Fannie Mae’s data suggests that rates will begin to drop in the back half of next year and reach 6.3% in the closing quarter of 2024. One potential option is to take out a 5/1 ARM now and refinance into a 30-year fixed-rate mortgage when rates look favorable. You’ll pay for closing costs again on the new mortgage, but you can avoid any of those adjustments and stay in your home.
- Will you be able to afford higher payments down the road? Perhaps you’re working an entry-level job now, and your money is tight. Your monthly earnings may look very different in five years, and a higher payment later may or may not create much stress on your finances. To get a better idea of how high the interest rate on a 5/1 ARM can go, take a look at the interest rate cap and see if it might give you trouble down the road.
In addition to considering these questions, you can research adjustable-rate mortgages to get a better sense of how they can impact your budget. The Consumer Financial Protection Bureau offers a handbook that can empower you with knowledge about these loans.
Is now a good time for a 5/1 ARM?
If you’re trying to buy a home within the next year, a 5/1 ARM may improve your ability to do so. Fannie Mae expects rates on 30-year mortgages to stay above 6.6% through the halfway point of 2024. This means that introductory rates on adjustable-rate mortgages will be more attractive. In fact, data from early October from CNET sister site Bankrate shows that the average rate for a 5/1 ARM was nearly one percentage point lower than the average 30-year mortgage rate.