There was a time, a few years back, when adjustable-rate mortgages – or ARMS – fell out of favor. This is because such loans were deemed to be too risky during the Great Recession. But now that the economy has stabilized, ARMs are starting to gain in popularity once again.
There are still risks with ARM loans, but as long as you know how a 5-year ARM works, what the risks are, and how to work with them, it might be a good loan type or you.
How Does a 5-Year ARM Mortgage Work?
The operative word in “adjustable-rate mortgage” is adjustable. The interest rate on the loan will change many times over the loan term. This distinguishes ARM mortgages from fixed rate mortgages, in which both your interest rate and your monthly payment remain constant throughout the term of the loan.
There are ARM mortgages of various durations, including one year, three years, five years, seven years, and ten years. In each case, your rate and payment remain fixed during the initial term of the loan. So for example, if you take a 7-year ARM mortgage, both your rate and monthly payment will be fixed for seven years.
After the initial fixed rate term, the loan converts to a 1-year ARM. And from that point on, it will remain a 1-year ARM until the loan is fully paid. For this reason, ARM loans are usually expressed as a “5/1 ARM”, or a “7/1 ARM”. The loan is fixed for the initial term of the loan, then converts to a 1-year adjustable.
Typically, the loan will have a term of 30 years, and will amortize down to zero by the end, just like a fixed rate mortgage will.
How Rate Adjustments are Calculated
The adjustment is usually determined based on the use of an underlying index, plus a fixed margin. For example, the index may be the index of 1-year US Treasury Bills or, more commonly, the London Interbank Offered Rate (LIBOR). After the fixed rate term of the loan expires, your new rate will be calculated based on whatever index rate is at the time of the adjustment. A margin will be added to the index rate, which might be something like 2.50%.
As an example, if the LIBOR rate is 0.75% at the end of the fixed term on a 5-year ARM mortgage, and the margin is 2.50%, your rate will be adjusted to 3.25%. That rate and payment will be in effect for one year, after which the rate will adjust again, each year until the loan is fully paid.
The 5-year ARM mortgage is by far the most popular ARM because it provides the optimal balance of low interest rate and a reasonably predictable fixed rate term.
Rate caps. ARM loans come with rate caps that limit how much your rate can increase. For example, the rate caps may be “2-2-5”, with each number meaning the following:
- The first number – 2 – limits the first adjustment to two percentage points. If you have a 5-year ARM mortgage at 3.00%, the maximum rate that you can be charged on the first adjustment is 5.00%.
- The second number – 2 – represents the maximum rate increase that can be imposed on any subsequent adjustments. Continuing the example above, if your rate adjusted up to 5.00% at first adjustment, the maximum you could be at for the second will be 7.00%.
- The third number – 5 – is the lifetime cap on the loan. That means that if your starting rate is 3.00%, your rate can never exceed 8.00% over the life of the loan.
The Benefits of a 5-Year ARM Mortgage
The primary benefit of a 5-year ARM mortgage is that it will start out with a lower rate than what you can get on a 30 year fixed rate mortgage. But there is another benefit that is almost never discussed, and that has to do with making prepayments on your mortgage.
When you make prepayments on a fixed rate mortgage, it does not affect your monthly payment. The principal balance goes down, you pay less interest, in the loan is paid off more quickly.
But if you make prepayments on an ARM loan, it can actually result in lower monthly payments. This is precisely because of the adjustment feature. Each time the interest rate adjusts, your monthly payment is recalculated based on the outstanding principal balance. If at the end of the fixed term on a 5-year ARM mortgage you make a principal payment of $20,000, it will lower the amount of your new payment.
If you can make a prepayment each year, it can enable you to lower your monthly payment with each adjustment. Naturally, this assumes that the rate adjustments will be significantly less than the amounts allowed by the loan caps.
The Risks of a 5-Year ARM Mortgage
There are risks involved any time you take an ARM mortgage, including a 5-year ARM mortgage. The primary risk, of course, is that your interest rate could rise considerably, increasing your monthly payment. For example, the monthly payment that you can easily afford when the loan rate was 3.00%, maybe out of reach if the rate adjusts up to 8.00%.
Most people get around that problem by refinancing at the end of the fixed term. However, if mortgage rates are considerably higher than what they are right now, there may not be any benefit in doing a refinance.
Should You Take a 5-Year ARM Mortgage?
5-year ARM mortgages are best suited when you are in a short-term homeownership situation. For example, if you only expect to live in the home for five years or less, the 5-year ARM mortgage can make sense. If you think you’ll be in longer than five years, or even that your stay will be permanent, you’ll most likely be better off with a fixed-rate mortgage.
A 5-year ARM mortgage can be an excellent financial decision under the right circumstances, but it is certainly not right for everybody, or in all situations.