5/1 Adjustable Rate Mortgage Definition – What Is 5/1 Arm Loan?

As a homebuyer, you may feel confused by the variety of mortgage programs available to you. Mortgage companies provide numerous choices for homebuyers and homeowners looking to refinance their current mortgage. It’s important to consider whether you’d prefer a fixed-rate loan or an adjustable-rate mortgage (ARM) loan, among other loan and term options.

If you’re seeking a less expensive monthly installment and don’t plan to stay in the house for very long, you might want to consider A 5/1 adjustable rate mortgage. It’s possible to qualify for a mortgage because the interest rate is cheaper than a 30-year fixed-rate mortgage for the first five years.

The 5/1 adjustable rate mortgage is a type of ARM with a fixed rate for the first five years of the loan term that is lower than the rates offered by conventional fixed-rate mortgages.

What Exactly Is a 5/1 Adjustable Rate Mortgage?

A loan with an adjustable interest rate and a fixed rate for the first five years is known as a 5/1 adjustable rate mortgage. After the initial fixed-rate period of 5 years, the interest rate on a 5/1 ARM loan is subject to periodic adjustments.

It’s common practice to use the terms “variable” and “adjustable” interchangeably. Most of the time, when individuals say they have a “variable-rate mortgage,” they actually mean one with an adjustable interest rate. It is unusual to find a mortgage with a truly variable interest rate, whose rate fluctuates on a monthly basis.

The initial fixed interest rate on an adjustable-rate mortgage (ARM) is known as the teaser rate since it is lower than the interest rate on a conventional fixed-rate loan. Seven- and ten-year fixed-rate terms are available, but the most popular adjustable-rate mortgage (ARM) term is five years.

After the initial fixed-rate period expires, the ARM adjusts depending on then-current market interest rates, with restrictions limiting how much the rate can rise with each adjustment. On average, the readjustment occurs once a year.

How Does a 5/1 Adjustable Rate Mortgage Work?

We’ll use a $250,000 loan amount as an example to compare the 5/1 adjustable rate mortgage to a fixed-rate mortgage so you can get a feel for how it works. For the sake of this example, let’s suppose a 30-year fixed-rate mortgage is available at a rate of 4%. Let’s see how that works out versus a 5/1 adjustable rate mortgage with 2/2/5 caps and a 3.5% APR to start.

An additional $1,193.54 (before taxes and insurance) is added to the monthly payment on a fixed-rate mortgage. Our adjustable rate mortgage’s first payment is $1,122.61. This results in a monthly savings of $70.93, however, keep in mind that this amount will change after the first five years of the loan. 

Your ARM payment would be $1,377.05 if the interest rate increased by the maximum amount permitted under the ceiling. If interest rates were to rise and the payment was to increase by the maximum allowed amount in the seventh year, the new payment at a rate of 7.5% would be $1,648.71. 

Finally, the lifetime ceiling on interest rate hikes is 5%, so your current payment in the 8th year would be $1,788.81 if rates went up significantly. When making financial plans, it’s crucial to factor in the possibility of such changes.

When Does a 5/1 Adjustable Rate Mortgage Adjust?

When you pay off the 5/1 ARM, the adjustment period begins. If you close on your loan on July 1st, 2022, the first time your interest rate would change would be on July 1st, 2027.

In the event of a rate change, your lender may recalculate the interest you will incur on your loan moving forward, which may be greater or fewer than the original rate. Your loan’s interest rate will change again one year later, and it will keep doing so annually until the conclusion of the loan’s 30-year term.

What Index Is the 5/1 Adjustable Rate Mortgage Adjust Based On?

The new rate is determined by multiplying an index by a margin you set forth in your mortgage paperwork, and this is how often the rate will change. Rates for adjustable-rate mortgages are typically determined by reference to an index such as the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index (COFI), or the Constant Maturity Treasuries (CMT).

In the past, adjustable-rate mortgages (ARMs) were pegged to a variety of factors, including the yield on 1-year Treasury notes, the 11th District cost of funds index (COFI), and the London Interbank Offered Rate (LIBOR). The Secured Overnight Financing Rate (SOFR) has replaced the former London Interbank Offered Rate (LIBOR).

The ARM mortgage rate will equal the index rate plus the margin. Take May of 2022 as an example, when the SOFR was 1.05 percent. The lending rate would be 3.05 percent with a 2 percent margin.

5/1 Adjustable Rate Mortgage: Pros and Cons

Though some homeowners may profit from an ARM, they are not all good candidates. Analyzing the benefits and drawbacks of a 5/1 adjustable rate mortgage might help you decide if it’s the best option for your situation.

Pros

• Reduced Initial Interest Rate. In the beginning, the rate will be lower than the rate you would pay with a fixed-rate loan of the same term. The extra money you save each month might be put toward the debt, invested, or used to make repairs and improvements to your home.

• Possibility of Lower Total Interest Expense. If you get a 5/1 adjustable-rate mortgage and use the money you save each month to pay down the debt, you’ll save a lot over the duration of the loan. If the interest rate rises, you will still pay less overall since the interest will be calculated on a smaller balance.

• A lot more housing. You may afford a larger mortgage and house in a better neighborhood because of the reduced payment.

• It might work out well for those only staying for a limited time. Moving out of a starter home even before the interest rate adjusts could be a good idea if you know you’ll be leaving in the near future. You’ll need to do some forward-thinking and preparation, but if everything pans out, you might be able to avoid a rate increase.

Cons

• The Risk of a Rising Monthly Payment Long-Term. The teaser rate on a 5/1 adjustable-rate mortgage is often lower than the going market rate for fixed-rate mortgages since investors are aware that the rate will rise over time if rates do. 
  
  Therefore, market conditions may cause your lengthy payment to increase, all the way up to the lifetime maximum. You can avoid this by switching to a fixed-rate loan through a refinancing process, if eligible.

• Interest rates tend to rise as time passes. Due to the likelihood of the interest rate increases, you should expect to pay more in interest as time goes on.

• Complexity. There are more variables involved in an adjustable-rate mortgage compared to a fixed-rate mortgage. Most homeowners probably don’t understand the nuances of rate caps, indices, and resets.

• This is a trap of interest alone. There are adjustable-rate mortgages (ARMs) that let you pay just the interest on the loan during the introductory period. You can get by with a smaller monthly payment and more breathing room in your budget, but beyond the fixed period, your payments will increase dramatically to cover the loan’s principle as well. 
  
  To put it another way, if home prices decline, you might find yourself unable to pay off the mortgage.

5/1 vs. 7/1 Adjustable Rate Mortgage: What’s the Difference?

The only difference between the 7/1 ARM and the 5/1 ARM is that the 7/1 ARM’s initial rate adjustment occurs for seven years instead of five. Compare them to the 3/1 or 5/1 and you’ll see a significant increase in the interest rate. Those who know they will be moving or refinancing within the next seven years can benefit from this longer fixed period.

After the initial fixed time ends, the rate will automatically adjust annually based on the index and margin. The maximum amount by which an ARM’s interest rate can increase either over the life of the loan or at each yearly reset is governed by the loan’s index.

Is a 5/1 Adjustable Rate Mortgage a Good Idea?

If you know you will be moving out of the house before the interest rate adjusts, an adjustable-rate mortgage may be a good option if the market rate spread is large. This is due to the fact that the interest rates charged upfront are sometimes far lower than those offered for a fixed rate.

The lower rate on an ARM can help give you financial flexibility if market conditions cause there to be a greater difference between adjustable rates and fixed-rate mortgages. As we saw previously, you can use the money you save on interest payments in the first few years to make a significant dent in the principle.

Consider a fixed-rate mortgage if you want to stay in the residence for an extended period of time. You will have long-term payment security as a result of this.

Bottom Line

After the initial fixed-rate period of five years in a 5/1 adjustable rate mortgage, interest rates are subject to annual adjustments based on market and economic factors. In the first five years, the interest rate may be much lower than it would be with a traditional fixed-rate mortgage.

If you don’t plan on keeping the house for more than five years, a short-term loan could be a good financial decision. Modifying your loan’s terms to reflect your new circumstances may be necessary to avoid interest rate increases that could devastate your monthly budget.

After the initial five years are up, homeowners who intend to remain in the house for a significant amount of time will have to deal with the unpredictability of annual mortgage payments.