Mortgage rates are still at all time low’s in 2018, but rates are starting to creep higher and experts predict they will continue to climb.
Most people choose to get a fixed-rate mortgage to lock in a low rate for the life of the loan.
However, in order to get the absolute lowest interest rate some homebuyers choose to get an adjustable-rate mortgage, called an ARM.
In this article we’re going to take a look adjustable-rate and fixed-rate mortgage loans so you can decide if a 5/1 ARM or a fixed-rate loan is best for you.
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What is a 5/1 ARM?
When you get an ARM, you will have a fixed interest rate for an initial period, usually between 3 to 7 years. The initial rate that is locked in is usually as much as 1% lower than a fixed rate loan.
After the initial period, the low rate will increase and adjust based on the terms of the mortgage term. The total loan length of an ARM is typically 30 years.
A 5/1 ARM is the most popular adjustable loan term. The 5 means that the initial rate is locked in for the first 5 years. The 1 means the rate will increase annually after the 5 year period is up.
Pros and Cons of a 5/1 ARM
Low introductory rate – The initial interest rate you receive in the beginning, as known as a teaser rate, or introductory rate is usually much lower than a fixed-rate mortgage. For example a 5/1 ARM will have rate that is about 1% lower than a fixed rate for the first 5 years of the loan.
Lower monthly payment – The lower interest rate in the beginning of your mortgage means your monthly mortgage payment will be lower.
Can afford to by a more expensive home – Because the rate is lower with an ARM your debt-to-income ratio will be lower as well allowing you to qualify for a more expensive house.
Caps – ARMs have caps for the interest rate and the mortgage payment. These caps ensure that your interest rate and payment never go higher than a predetermined number.
They’re complicated – ARMs are full of complex terms and rules. Each ARM is unique and has it’s own terms, floors, caps, etc. They are much more complex than your standard fixed-rate loan.
Your payment and rate will increase – After the initial low rate you receive with an ARM, the rate and payment will continue to increase on an annual basis.
Refinancing might not help – Some people believe they can get an ARM to take advantage of the low interest rate and just refinance into another ARM, or a fixed-rate mortgage after the initial rate is up. However, if interest rates have risen since you got your loan, rates could be much higher than they were perviously.
Pre-Payment Penalty – In some cases an ARM will have a pre-payment penalty if you pay off the loan early.
Types of ARMs
Interest Only ARMs
An interest-only ARM is similar to a hybrid ARM, however, none of your payment will go towards the principle balance. There is an initial period of a fixed interest rate, when the initial period ends the rate will increase and adjust based on the terms of the mortgage loan.
A hybrid mortgage is broken down into two phases. The initial period offers a low rate for a fixed period of time, typically 3-10 years. After this initial period the interest rate can increase or decrease depending on an index of mortgage rates.
- 3/1 ARM. Interest rate is fixed for 3 years and changes annually for 27 years.
- 5/1 ARM. Interest rate is fixed for 5 years and changes annually for 25 years.
- 7/1 ARM. Interest rate is fixed for 7 years and changes annually for 23 years.
- 10/1 ARM. Interest rate is fixed for 10 years and changes annually for 20 years.
Understanding ARM Terms
ARMs tend to have some complicated mortgage terms that you need to be familiar with in order to understand your mortgage term.
- Adjustment frequency: The frequency the rate is subject to change following the initial period of a set interest rate.
- Benchmark index: The index in which interest rates are set based on, usually a margin is also included to cover the lenders fees.
- Teaser rate: The initial low interest rate an ARM offers that is set for a period of time, typically 3,5,7, or 10 years.
- Interest-rate cap: The maximum amount your interest rate can adjust to.
- Payment cap: The maximum amount your mortgage payment can adjust to.
- Floor: Limits how low the rate can adjust to.
15 Year Fixed-Rate Mortgage
A fixed-rate mortgage does not change, the rate you get stays the same from the first day of the mortgage until the last.
If you’re looking to try and get the lowest possible interest rate for your loan, a 15 year fixed-rate loan may be a great option for you.
15 year loans come with a rate that is similar to that of a 5/1 ARM but is locked in for the life of the loan.
The only downside is that the monthly mortgage payment will be several hundred dollars higher than it would be with an ARM or a 30 year fixed-rate loan.
Fixed Rate vs. ARM
If you are trying to decide which is better? A 5/1 ARM or a fixed-rate mortgage it will depend on your situation.
A fixed-rate mortgage is the most popular mortgage term used today. With a fixed-rate loan you’re able to lock in todays low interest rate for the life of the loan.
However, if you do not plan on living in the home for at least 5 years, then a 5/1 ARM can save you quite a bit of money. However, if you do plan on staying for longer than 5 years a fixed rate mortgage is probably your best option.
When an ARM is a good idea?
You do not plan on keeping the home for more than 5 years.
As an example, let’s say you plan on staying in the home for less than 5 years and you purchase a $200,000 home. If you got a 30 year fixed rate mortgage with an interest rate of 3.8% your monthly payment would be $745.
If you got a 5/1 ARM with a 2.875% interest rate, your payment would be $650 a month, that’s a savings of $95 per month which equals a savings of $6,000 over the first 5 years of the loan.
Not only would you $6,000 on the monthly payments, the ARM will allow you to pay an extra $3,000 in principle for a total of $9,000 in savings.
You are expecting to pay off the mortgage within 5 years.
If you are either expecting a big pay day, or have the savings to pay off your mortgage in 5 years or less than an ARM will be the cheaper option.
You expect your income to increase and you need to buy a home that is more expensive.
If you expect your income to increase in the coming months or years and you want to purchase a little more home than you would otherwise be qualified for with a fixed-rate loan than a 5/1 ARM is a good idea.
For example, a medical student who is close to finishing their medical degree and becoming a doctor could get a 5/1 ARM to qualify for a more expensive home that they can easily afford later on.
Interest rates are expected to decline
If interest rates are high and are expected to decline in the future then an ARM may be a good way to get a low interest rate now, then refinance into a lower fixed rate when rates come down.