What is a 5/1 ARM?

A 5/1 ARM is actually a 30-year mortgage loan.

The ‘5’ means it has a fixed rate for the first 5 years of the loan. After that, the interest rate can change every ‘1’ year, for the remaining 25 years, depending on how markets are moving.

An adjustable rate means your mortgage rate and payment could rise after the 5-year fixed-rate period. There’s a chance they could fall, too, but this is much less likely.

That said, a lender cannot jack your rate up indefinitely. ARM rates can only move up or down a certain amount, within restrictions called ‘floors’ and ‘caps.’ (We explain this in more detail below.)

The amount your ARM loan’s interest rate will adjust depends on several factors:

What is a 15-year fixed-rate mortgage?

Like 5/1 ARM rates, 15-year fixed mortgage rates are generally lower than 30-year fixed rates (which are the standard for most mortgages).

But, there’s a key difference between 15-year fixed loans and 5/1 ARMs.

With a 15-year fixed-rate mortgage — as the name implies — your interest rate is fixed for the full loan term of 15 years. That means your rate and payment will never change, no matter what’s happening with the economy.

When you have a fixed-rate mortgage, the only way your loan terms can change is if you decide to refinance (whether for a lower rate, to take cash-out, or for another reason).

Thanks to the security they offer, most borrowers choose a 30- or 15-year fixed-rate mortgage over a 5/1 ARM.

But there are certain scenarios where ARM loans become more popular — usually when rates are on the rise, or when a homeowner only wants to stay in their home a few years. (Thus, they may benefit from the low fixed-rate period and move before their rate changes). 

Low-rate vs high-rate economy

Borrowers in 2020 need to take a new look at their mortgage loan options and consider which loan works best for their refinance or purchase.

In a low-rate environment, more borrowers choose fixed-rate loans.

For example:

Hybrid ARMs

Before the housing crisis in the late 2000s, homebuyers could find some pretty creative ARM programs. You could find loans with rates that changed every month. Some even permitted loan balances to increase each month.

How 5/1 ARM rates adjust

After the introductory fixed-rate period, ARM rates can readjust each year. Whether or not your ARM interest rate changes — and how much it moves — depends on which rate index it’s tied to.

Previously, most adjustable-rate mortgages were based on an index called the 1-Year LIBOR. (LIBOR stands for London Interbank Offered Rate).

But as of 2020-2021, the majority of ARMs will be based on the SOFR index instead. SOFR stands for Secured Overnight Financing Rate.

Avoiding the technicals, what you need to know is that SOFR is a measure of current interest rates in the overall lending market.

Your ARM rate would likely be based on the SOFR overnight lending rate, plus a certain percentage. This is called your ‘margin.’

For example, say your current rate on a 5/1 ARM were 2.5%, but you are nearing the end of your 5-year fixed period.

The current SOFR overnight financing rate is at 0.10%. The margin on your loan is  2.75 percent margin (this is fairly typical). If your rate were adjusting on this day, your new mortgage rate would rise from 2.5% to 2.85% (the index plus the margin).

But if the current SOFR rate were 1.5%, your rate would rise from 2.5% to 4.25% — in one month. Your mortgage payment could rise by hundreds of dollars. That’s why it’s important to consider the ‘worse case scenario’ when accepting an ARM loan.

So how do you figure out your ‘worse case’ payment? Read on.

ARM ‘caps’ and ‘floors’

There’s more to your ARM rate than simply taking its base index and adding a few percentage points.

There are also rules that restrict how much your rate can adjust. Imagine that your starting rate was 3%, and that was fixed for five years. Now, your 5/1 is adjusting for the first time.

Suppose its terms are 2/2/5. This means your interest rate:

• Can increase no more than 2% at the first adjustment
• Can increase no more than 2% for each future adjustment
• Can never go higher than 5% above your initial interest rate

Your rate started at 3%, which means right now, it can’t go higher than 5%. And over the life of the loan, the rate can never exceed 8%.

As of this writing, Freddie Mac’s average 5/1 ARM interest rate is 2.88%.

Is A 5/1 ARM a good idea?

A 5/1 ARM can work out in your favor, but only under the right conditions. There’s probably no reason to choose a 5-year ARM when fixed rate loans are available at similar or lower rates.

But in normal market conditions, here’s when a 5/1 ARM might be a good idea.

ARM benefits

Benefits of a 15-year fixed loan

There’s another way to secure the lowest possible interest rate — if you can afford higher payments.

Traditionally, the 15-year fixed-rate mortgage carries an interest rate that’s similar to that of the 5/1 ARM.

In today’s market conditions, the 15-year fixed can offer about a half percentage point rate reduction compared to the 5/1 ARM.

And unlike the ARM, the interest rate is fixed for the entire term of the home loan — no need to worry about rate increases.

The catch? You get half as much time to clear your loan balance, so your monthly payments will be higher. But while your loan gets retired in half the time, your payment is NOT twice as high. Not even close.

At the time of writing (November 2020), Freddie Mac’s average rates are as follows for a $300,000 loan amount:

• 30-Year Fixed — 2.81%
• 15-Year Fixed — 2.32%

The lower interest rate keeps your 15-year payment much lower than twice the 30-year payment. In fact, at today’s average Freddie Mac rates put principal and interest payments as follows on a $300,000 loan:

• 30-year loan — $1,225/month
• 15-year loan — $2,018/month

Clearly, the disadvantage of a 15-year loan is that it can be more difficult to afford the higher payment.

Fixed-rate mortgage versus ARM

If you plan to keep your home (and your mortgage) for just a few years, the 5/1 ARM may be a smart choice. At least, in ordinary market conditions when its interest rate can be lower than that of the 15-year loan.

Plus, you’d have the option of making a higher monthly payment when you want to and can afford it, but you’re not locked into a payment obligation that might be unaffordable.

When to refinance out of an ARM

Homeowners who currently have a 5-year ARM — or any kind of ARM whose introductory rate period is set to expire — can lock in a low fixed interest rate in today’s mortgage market and avoid the ARM loan’s rate changes.

You’ll have a wide variety of refinancing options which include: