Is a 5/1 Adjustable Rate Mortgage Right for You?

By Published On: November 18, 20214 min read

Choosing the right mortgage is just as important as choosing the right property. Whether it’s a commercial investment or a family home, you want to make sure the mortgage works with your budget, savings and credit rating.

You can choose from a fixed rate mortgage with a consistent interest rate for the duration of your loan, an adjustable rate mortgage, whose interest rates vary throughout the life of the loan or a hybrid adjustable rate mortgage, where the interest rates remain stable for a given period, after which they vary based on a number of different factors. There are multiple types of mortgages within these larger categories, but for this article, we’re looking at 5/1 Adjustable Rate Mortgages.

What Is a 5/1 Adjustable Rate Mortgage (ARM) Loan?

A 5/1 ARM is a mortgage loan where the interest is set at a fixed rate for five years, after which it switches to an adjustable rate for the remainder of the loan. That initial five year rate is also called a teaser rate.

A Note On Rate Caps

You’ll likely be in for some rate hikes when the five years are up, but there are still rate caps in place, including:

  • Adjustment intervals: The 1 in 5/1, which tells you how often the interest payments will go up after the initial five year period.
  • Initial cap: A limit on the amount the rate can rise in year six of the mortgage. No matter the market conditions, this won’t be higher than 2%.
  • Subsequent caps: The amount the rate is allowed to go up between the first increase and the increases after that before the final year.
  • Lifetime cap: As long as you’re paying off the loan, the mortgage interest rates can’t go above 5% for the life of the loan.

These caps don’t protect against large rate hikes, only set limits of exactly how high those hikes can go.

How ARMs Work

5/1s are the most popular type of hybrid adjustable rate mortgages, but there are others, like 3/1, 7/1 or 10/1. No matter the type, during the first 3- to 10-year period, the mortgage may be considerably lower than average, which is part of the reason why they’re so popular, but they can get much higher later. After the fixed period, your mortgage contract will have specified how the new rate is calculated, generally adding an index number to the specified margin in the documentation.

These indexes, according to Rocket Mortgage, might include the Cost of Funds Index (COFI) and the Constant Maturity Treasuries (CMT). With each interest rate change, the interest payment will be recalculated to ensure the loan will be paid off by the end of the term, often 30 years.

Example of a 5/1 ARM in Commercial Real Estate

5/1 and other types of ARMs are available for both single family and commercial properties. For commercial properties, according to Assets America, ARMs “are best for people who do not intend to own their commercial property for a long period of time.” Commercial property owners who obtain this type of loan likely plan to refinance when the initial five years expires.

Let’s say you have a four family multifamily home with a purchase price of $250,000, and a 5/1 ARM with a 3.5% interest for the first five year, a 2% initial cap and a 5% lifetime cap. The first interest payment will be $1,122.61. In year six, if it increases by the maximum allowed 2%, you’re up to $1,377.05. If in year eight your increases hit the maximum allowed 5%, you’re looking at $1,788.81.

It’s critical to either budget for those increases, or have a refinancing or selling plan.

Advantages of a 5/1 ARM Loan

The biggest advantage of a 5/1 ARM is the low introductory rates for the initial five-year period. If you have particularly lucky timing, it is possible for the interest rates to drop before the end of the first five years, which could mean even lower payments for as long as the market conditions remain favorable to mortgage holders. It’s also a good option if you don’t plan to live in the property for a long time, or plan to refinance.

Disadvantages of a 5/1 ARM Loan

The biggest disadvantage of a 5/1 ARM is the likelihood of higher interest rates after the first five years, and the unpredictability of exactly how high those rates will be. Because of this, you might end up getting trapped into a mortgage you can’t afford for years, if interest rates aren’t in your favor.

Lower Interest Payments Now, Higher Risks Later

If you have a high appetite for risk, prefer lower upfront payments and are likely to refinance, a 5/1 ARM might be right for you. If you prefer stability and have a lower appetite for risk, it’s best to stick with a fixed rate mortgage.

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