What is a 5/1 ARM?
A 5/1 ARM is a common type of 30-year adjustable-rate mortgage. The term 5/1 refers to the length of the first mortgage — fixed for the first five years, then the interest rate adjusts once yearly after that based on the index stated in the loan agreement. Another common mortgage is the 5/6 ARM, which adjusts every six months after the initial period.
When does a 5/1 ARM adjust?
When your 5/1 ARM adjusts is dependent on when you close the loan. For example, if you closed your loan on July 1, 2020, the first rate adjustment will happen on July 1, 2025.
When this adjustment occurs, the principal interest of your loan is recalculated going forward, and you pay the new monthly payment based on the prevailing interest rate, which could be higher or lower than the initial rate. The following year, your loan will adjust again on the same date, and the process will repeat throughout the life of the mortgage.
What index does the 5/1 ARM mortgage use?
For many years, these loans have been tied to either the yield on 1-year Treasury bills, the 11th District cost of funds index (COFI) or the London Interbank Offered Rate (LIBOR). However, LIBOR has been phased out in favor of a new index called the Secured Overnight Financing Rate (SOFR).
The mortgage rate will be the rate of the index, plus a stated margin. For example, in May 2022, SOFR was 1.05 percent. If the margin is 2 percentage points, the loan rate would be the sum of the two, or 3.05 percent.
5/1 ARM vs. 10/1 ARM
The 5/1 ARM is similar to the 10/1 ARM, except the initial rate adjusts after the first five years rather than 10 years. Generally, the interest rate on the 5/1 will be a little lower than the 10/1, reflecting the shorter time the initial rate is locked in.
5/1 ARM vs. 7/1 ARM
The 5/1 ARM is similar to the 7/1 ARM, except the initial rate adjusts after the first five years rather than seven. Rates will be higher than the 3/1. This loan can be a good choice for people who know they want to move or refinance within five years.
With all these loans, the rate resets every year after the initial fixed period based on the stated index plus a margin. There is a cap on how much the interest rate can rise over the life of the mortgage.
What are the pros and cons of a 5/1 ARM?
The biggest and possibly only benefit of a 5/1 ARM is more affordable monthly payments compared with a 30-year fixed mortgage. In spring 2022, ARMs came with interest rates about a full percentage point lower than comparable 30-year fixed loans.
The lower payment can be especially attractive if you’re stretching to afford the home or qualify for the monthly payment.
If interest rates are falling, then your monthly payment will also fall after the initial period and during future resets.
This can also be the big disadvantage of the 5/1 ARM. If rates have moved up, your payment will increase. ARMs typically have a limit on each reset, though. A 1 percentage point up move cap is common.
https://www.bankrate.com/mortgages/what-is-a-5-1-arm/