What Is a 5/1 ARM Loan?

Written By Beth Weber
Last updated October 28, 2021

Note: We receive a commission for purchases made through the links on this site. Our sponsors, however, do not influence our editorial content in any way.

Loans
October 28, 2021

Simple. Thrifty. Living.

Buying a home is one of life’s biggest milestones. To many, homeownership represents security, comfort and upward mobility. Reaching this milestone means you have to manage many moving parts, including choosing and qualifying for your financing.

In fact, the most important part of a home purchase may the choice of financing. A mortgage is a 30-year commitment that will have a tremendous impact on your monthly budget. You will need to decide if you want to take out a shorter-term loan, one with a fixed interest rate or one with variable interest. Sound complicated? It can be, but choosing the right mortgage doesn’t have to be a challenge as long as you understand the different loan types and financing terms.

A 5/1 ARM loan is a 30-year mortgage that begins with a low five-year fixed interest rate. In general, this rate is about one point lower than the average, allowing home buyers to pay off more principal at the beginning of the loan. Your payments should be lower during this period as well.

After the first five years, the rate will increase to a variable rate that reflects current market conditions. Although 5/1 ARM loans come with some protections for the homeowner, including interest rate caps and life-of-the-loan limits, your payments during this phase are somewhat unpredictable. 5/1 ARM loans are popular among some property buyers. Whether it is the loan for you depends on several factors. 

Making the Decision

These decisions will depend on several factors, such as how long you plan to live in the house, your chances for increased income in the coming years and if you might want to refinance in the future. You have a lot riding on your financing choice. For some borrowers, a 5/1 ARM loan works best for their situation. Depending on your needs, you might want to explore this adjustable loan.

The complication with this type of loan happens in the last 25 years when the interest rate changes. Before you take out an ARM loan, you need to understand the variable rate. After the first five years, the interest rate almost always goes up, although there is a slight chance that market conditions will drive down the rate instead. Changes in the real estate market will affect you, and the real estate market always fluctuates. You must prepare to make higher house payments.

Lenders

Lenders cannot just raise your rate without limits, however. Your ARM loan will specify just how far up or down your rate can go according to the floors or caps placed on the loan. Your interest rate will adjust according to the following: 

  • The Index Rate– A financial indicator that is based on certain benchmarks such as the prime rate, US treasury bill and note rates, etc. 
  • The Margin: The amount lenders add to your interest rate that is above the index rate.
  • Floors: Limits on how low your interest rate can go.
  • Caps: Limits on how high your interest rate can go.
  • Lifetime Limits: The limit on rate changes during the life of the mortgage.

So while a 5/1 ARM loan is somewhat unpredictable, you are not at the mercy of out-of-control interest rates no matter how the market changes. The mortgage comes with some built-in protections for homeowners.

For some buyers, this loan is an excellent choice. You may benefit from an ARM loan if you are not planning to live in the house for over five years. You may want to renovate it and flip it for profit, or you may have a job that involves frequent moves. In those cases, you will probably sell the house before the variable rate kicks in. That way, you enjoy the initial low-interest rates without the higher payments later.

Who Can Benefit

If you are young and just building a career and/or family, you can benefit from lower mortgage payments for the first five years while you increase your income. Also, more of your money will go toward the principal, which will help keep your payments down when the loan moves into the variable phase. If you plan well, the 5/1 ARM interest changes will not harm you.

Not everyone should gamble with a 5/1 ARM. If you plan to live in your home for a long time, you should probably stick to a fixed-rate loan. If interest rates fall to a much lower level, you can consider refinancing to lower your payment. Refinancing an ARM loan is more difficult and can be too costly to be practical. 

These loans are not for people who crave predictability or those who have no savings. If the interest rate goes up sharply, your monthly payments could be too high for you to meet, leading to missed and late payments. Some buyers suffer damage to their credit scores or even face foreclosure. To be safe, you must have the resources to handle the rising interest rate.

You need to be as careful about choosing your mortgage as you are about choosing your home. Your life will change over the years and your finances probably will as well. A 30-year mortgage is an enormous commitment, so you want the type that will fit your short- and long-term needs. For some people, that is a 5/1 ARM loan, and financing that starts off with a low rate that changes only after five years. This loan type comes with some risks, but it can give you initial benefits that are worth the uncertainty of the variable rate.

About the Author

Beth Weber

I am an experienced freelance writer with a rich background in teaching, ad creation, and healthcare publications. I have served as an editor of the historic Monroe County Appeal newspaper, been a contributing editor to Maine St. Magazine, and written articles for numerous websites, including Doctor Wise and 50plus-lifestyle.com. My specialties include legal issues, health care, insurance, 50-plus lifestyle concerns, and cybersecurity. Humor is important to me, and I can write satirically as well as seriously. I earned my MFA in creative writing from Spalding University and my MA and BA in English from Truman University.

  • No comments yet. Be the first to get the conversation started. Here's some food for thought:

    Do you have any thoughts?

Submit a Comment

Your email address will not be published. Required fields are marked *