What is a 5/1 ARM Loan – All You Need to Know

Are you a homebuyer currently exploring mortgage options? Then you are in luck! Today’s home hunters have several lending options at their disposal, and the 5/1 ARM loan is one of them. What is a 5/1 ARM Loan? Read all about it here.

When you choose a 5/1 ARM (adjustable-rate mortgage), which also happens to be the most common ARM variant, you will notice that the interest rate remains the same during the first five years. After that, it gets adjusted once every year. Just make sure that you consider everything associated with a 5/1 ARM because you might end up making higher monthly payments than expected.

An Overview of 5/1 ARM

The numbers 5 and 1 are extremely important. Please keep that in mind when exploring an ARM. The first digit represents the five-year duration of the fixed interest, while the second digit expresses the adjustment of the interest once per year after the five-year period ends.

Most mortgages are fixed-rate loans, which means the interest rate will not change until you refinance. Here is an example – if the initial interest rate is 5.75%, it will remain so for as long as the loan lasts.

Introductory rates of a 5/1 ARM are usually lower than the rates of a 30-year fixed-rate mortgage, which is quite popular. The interest rates of a 5/1 ARM can be 0.5% to 0.75% lower. During the first five years, an ARM loan mortgage broker can guarantee this low interest rate and payment. However, it can be adjusted up or down every year after the first five years based on the benchmark rate.

How Does 5/1 ARM Work?

Thankfully, figuring out how a 5/1 ARM works is quite simple. All it takes is a bit of basic mathematics.

A 5/1 ARM begins with an introductory, or “teaser,” interest rate. Now, after the five-year intro period expires, the interest rate changes to a “floating” rate based on market conditions instead of your financial situation.

How much you need to pay depends on two primary factors: your loan’s index and its margin.

1. Index

The index is the interest rate that highlights current market conditions. However, not every lender uses the same index when adjusting the floating rate of an ARM.

For example, certain lenders might resort to the U.S. prime rate, which is often the lowest interest rate available. These lenders leverage the U.S. prime rate as a benchmark for setting interest rates on mortgages. The prime rate is usually about 3% above the federal funds rate used by banks to lend money to each other.

Other lenders rely on the Secured Overnight Financing Rate, or SOFR, which is a measure of the cost of borrowing cash overnight based on Treasury securities.

2. Margin

In a 5/1 ARM, a lender adds a few additional percentage points, known as the margin, to the index after the five-year introductory phase. The margin should be outlined in your initial loan paperwork, and it never changes. It just differs based on the lender and the type of loan.

After combining the index and margin, the interest rate will be revealed.

So, if the index rate is 3% and the margin is 3.5%, the new mortgage interest rate would be 6.5%. This might be higher or lower than your initial interest rate, or even the interest rate you paid last year, depending on marketing conditions when the loan adjusts.

The Requirements;

What is a 5/1 ARM Loan? To answer this question, a few other aspects need to be discussed. To that end, we will tell you about the requirements you need to fulfill to be eligible. The requirements depend on the type of loan you get, such as a conventional mortgage or a Federal Housing Administration (FHA) mortgage. There is also the matter of the lender you choose.

Here is a list of the requirements of a conventional 5/1 ARM.

• Down payment of at least 5%
• Minimum credit score of 620
• Debt-to-income (DTI) ratio below 45%, but a few lenders may allow a ratio up to 50%

Here are the requirements of an FHA 5/1 ARM.

• Down payment of 3.5% with a credit score of at least 580 and down payment of 10% with a credit score between 500 and 579
• Minimum credit score of 500
• DTI ratio of 43%, but some lenders may approve an ARM for a borrower with a 50% DTI ratio

Comparing 5/1 ARMs:

If you are planning to acquire a 5/1 ARM, keep the following factors in mind for the best deal.

• Introductory Rate:This is the interest rate that you have to pay during the first five years of a 5/1 ARM.
• Adjustment Interval:This is the amount of time between adjustments in the interest rate of an ARM. For instance, the adjustment interval for a 5/1 ARM is one year.
• Initial Adjustment Cap:The initial adjustment cap limits how much the interest rate can go up or down after the end of the introductory rate. Generally, the initial adjustment cap is 2% or 5% above or below the teaser rate.
• Subsequent Adjustment Cap:This puts a limit on how much the interest rate can increase or decrease after the first adjustment. Typically, this cap is 1 or 2 percentage points above or below the previous rate.
• Lifetime Adjustment Cap:This restricts the overall increase or decrease in the rate throughout the life of a loan. The cap is usually 5 percentage points above or below the initial rate.

Advantages and Disadvantages of 5/1 ARM Loans

A 5/1 ARM loan has certain advantages and disadvantages, just like any other mortgage.

Benefits of 5/1 ARM

• Many ARMs come with an introductory interest rate, which much lower than what you would have to pay if you choose a fixed-rate mortgage.
• The monthly mortgage payments you make to your mortgage broker might be lower for an ARM than a regular mortgage during the low-interest period.
• If you expect to buy and sell your property before the expiry of the five-year introductory interest rate, you may just save more money that if you had bought a home with a traditional mortgage.
• After the five-year fixed-rate period ends, the interest rate of the ARM might drop, helping you save money on interest charges.

Drawbacks of 5/1 ARM

• As soon as the promotional interest rate expires after the five years, the new interest rate might be higher.
• ARMs are quite difficult to understand than traditional mortgages because of the interest calculations, which are required after the end of the teaser interest rate.
• While the loan might be easier on your finances during the first five years, your monthly mortgage payments could go up after the new interest rate is levied. This might add to the overall costs, and it could be higher than a regular mortgage.
• Certain lenders may demand a higher down payment, for a 5/1 ARM, of up to 25%. This is higher than they charge for a traditional mortgage.
• The closing costs and prepayment penalties might contribute to the expenses of the refinancing of a 5/1 ARM.

Should You Get a 5/1 ARM?

What is a 5/1 ARM Loan? You should already have your answer, but there is still one more thing you should know. Is this loan suitable for you? It is a flexible and potentially cost-effective mortgage option, perfect for individuals planning to sell their properties within a few years. If you want to hold on to your home, though, explore other options.

FAQs

Q1. Can you refinance a 5/1 ARM before the rate adjusts?

A1. Yes, many borrowers refinance their 5/1 ARM into a fixed-rate mortgage before the adjustment period begins to lock in a stable interest rate and avoid future rate increases.

Q2. What happens if interest rates drop after the adjustment period?

A2. If market rates drop after your five-year fixed period, your ARM rate may decrease too—potentially lowering your monthly payments depending on your lender’s index and margin setup.

Q3. Are 5/1 ARMs available for investment properties?

A3. Yes, 5/1 ARMs are available for investment properties, but lenders may require higher credit scores, larger down payments, and tighter debt-to-income ratios to approve such loans.

Q4. Can your interest rate decrease with a 5/1 ARM?

A4. Yes, your interest rate can go down after the five-year period if the market index drops. However, the final rate also depends on the fixed margin added by your lender.

Q5. What’s the difference between a 5/1 ARM and a 7/1 ARM?

A5. The main difference is the fixed-rate period. A 5/1 ARM has five years of fixed interest, while a 7/1 ARM offers seven years before annual rate adjustments begin.