A 5/1 interest-only ARM offers low monthly payments at first, which could save you a lot of money on your mortgage payment.
Yes, payments increase later, but at today’s high mortgage rates, this could be your key to owning a home.
Still, you should plan to exit the loan before its payments increase.
Here’s how to navigate a 5/1 interest-only ARM loan.Check you 5/1 interest-only ARM eligibility.
What’s in this article?
A 5/1 interest-only adjustable-rate mortgage — also known as a 5/1 interest-only ARM or a 5-year IO ARM — is a home mortgage loan that does not conform to Freddie Mac and Fannie Mae’s lending guidelines.
Compared to a conforming, 30-year fixed-rate mortgage, a 5/1 interest-only ARM has two big differences:
- It charges only interest at first: During the first five years of the loan’s term, you’ll be required to pay only the interest on your mortgage balance — not the principal. You could pay down principal if you want, but you don’t have to
- It doesn’t lock in a permanent rate: You’ll have the same interest rate during the first five years of the loan. After that, the rate will change, annually, for each the loan’s remaining 25 years
These differences mean 5/1 interest-only ARMs require lower payments during the loan’s first five years when compared to traditional 30-year financing.
Paying less each month can increase your borrowing power, helping you afford a larger loan amount. Or, you could make a lower payment on the same home, investing the money you save elsewhere.
A 5/1 interest-only ARM is a 30-year mortgage, but it’s not fully amortized from Day 1 like a traditional 30-year loan or a regular 5-year ARM. This means the principal on the loan — the amount you borrowed — will stay the same during the first five years. That is, unless you intentionally pay down principal, which is allowed.
If you choose not to pay it down, the principal stays the same because your payments would cover only the interest due on the principal.
Later, typically in five to 10 years, you’d start making principal and interest payments. Since the full loan balance would be spread across 25 years instead of 30, you’d owe more on principal each month compared to a regular 30-year loan’s payments.
Mixing principal into your payments won’t be the only change in five years. The loan’s interest rate will change, too. This could make the payments go even higher. (The rate could also go down, depending on market conditions.)
Interest-only ARM purposes
Maybe you’re wondering why a homebuyer would use this kind of loan? Why trade lower payments now for bigger payments five years down the road?
A lot of buyers should not get this type of loan. For example, if you’d rather sign your mortgage papers and forget about the loan — other than once a month, when you send in the payment — a 5/1 interest-only ARM isn’t for you.
5/1 IO ARMs are best for homebuyers who plan to use them strategically: buyers who measure the loan’s potential for savings against its potential risk. These buyers plan, in advance, to claim the loan’s savings, during the first five years, and then exit the loan before its costs go up.
Often, 5/1 interest-only ARM borrowers have a specific goal in mind, and the loan offers a way to achieve that goal.
An interest-only ARM can be a powerful tool for people who know how to use it.
This kind of financing works well for people who:
- Flip homes: A 5/1 interest-only ARM allows for low monthly payments while you restore a home. That way more money can go into the restoration. Then, you’d sell the home for a profit, before the loan’s payments change
- Will move soon: When you know, for certain, that you’ll be selling the home in a few years, a 5/1 interest-only ARM could save money in the meantime. For best results, invest the saved money elsewhere. Try to earn more than the house appreciates
- Invest in real estate: Real estate investors often use temporary financing like 5/1 interest-only ARMs. That way they pay less money while deciding whether to refinance or sell the property
- Will refinance soon: Someone who plans to refinance the loan within a couple years could use a 5/1 interest-only ARM to save money for a while. This might be the case for someone who’s getting married in a couple years and wants to buy a home now but refinance it into both spouses’ names later
All of these strategies have one thing in common: They use the 5/1 interest-only ARM as temporary financing. In each of these scenarios, the homeowner plans to save money now and then exit the loan within five years.Get started on your 5/1 interest-only ARM.
You won’t need a mortgage calculator to figure out your initial payment on a 5/1 interest-only ARM, but a regular calculator will help. Here’s the formula:
Loan amount X interest rate / 100 / 12
Let’s say you’re borrowing $320,000 at an interest rate of 6.5%.
- Multiply the loan amount ($320,000) by the interest rate (6.5%). You’ll get a huge number, $2,080,000, but don’t worry.
- You’ll divide that number by 100 to get $20,800 which is the annual amount of interest due on the balance.
- Divide that number by 12 to see the monthly interest due. In this case it’s $1,733. That’s the monthly payment.
How does this payment compare to the payment on a 30-year fixed-rate mortgage? The following table shows sample payments for both kinds of loans at different loan amounts:
|20% down payment||$80,000||$120,000||$160,000|
|30-year fixed payment**||$2,023||$3,034||$4,045|
|Monthly payment reduction||$290||$434||$579|
*Interest rates shown are for example purposes only and may not be currently available. Your rate will be different. Get a personalized mortgage quote here. **Does not include taxes, insurance, HOA, or other dues or fees.
A 5/1 interest-only ARM can expand your home buying budget by allowing a larger loan size for the same monthly payment.
Buyers of high-value real estate may take this benefit a step further by getting a jumbo, or non-conforming, loan amount.
Jumbo loans exceed the annual conforming loan limit set by Freddie Mac and Fannie Mae. For single-family home buyers in most areas, the 2022 loan limit is $647,200. (Limits are higher in high-value places like Seattle, San Francisco, and New York City.)
The larger the loan, the more money you could save during a 5/1 interest-only ARM’s first five years. But larger loans will cost even more later, too, once the loan’s initial period expires.
5/1 interest-only jumbo borrowers need an exit strategy before getting into the loan.
Some buyers want an interest-only loan that has a fixed interest rate. This is possible. Some lenders will underwrite 30-year fixed-rate loans that charge only interest for the first 10 or 15 years of the loan’s term.
Even with a fixed rate, these loans will increase their payments when the interest-only period ends. In fact, the payments may increase a lot, especially when the loan has a longer interest-only period.
Still, the stability of a fixed rate can offer an appealing sense of certainty to buyers — even buyers who plan to keep the loan for only a few years.
This type of home financing isn’t for everyone. Here are some pros and cons of 5/1 interest-only ARMs.
- Can offer lower interest rates compared to traditional mortgages
- Paying only interest lowers monthly payments over first five years
- Nice for temporary financing of larger real estate investments
- Mortgage rate will start changing after first five years
- Payments will increase in five years when principal gets added in (some 5/1 IO loans come with 10-year interest-only periods)
- Non-conforming loans could have prepayment penalties; they’re not covered by consumer protection laws
5-year interest-only ARM alternatives
Standard adjustable-rate mortgages
- 3-year ARM
- 5-year ARM
- 7-year ARM
- 10-year ARM
- VA adjustable-rate mortgage
- FHA adjustable-rate mortgage
Interest-only adjustable-rate mortgages
Aren’t 5/1 interest-only loans “bad”?
Loans that charge only interest have bad reputations. Loans with adjustable rates do too, especially after ARMs helped fuel the housing collapse of 2008.
A 5/1 interest-only ARM combines both of these notorious traits. Isn’t that bad?
Truth be told, this kind of financing can be bad for borrowers who don’t know what they’re doing. Someone who gets drawn in by a low payment, but doesn’t plan for the risk, could get in too deep.
But savvy buyers and investors can use a 5/1 interest-only ARM to their advantage without ever experiencing the loan’s unpredictability.
Understandably, even experienced buyers worry that paying only interest each month simply kicks the principal down the road for later. It does. But did you know that a standard 30-year loan kicks most of the principal down the road?
A standard amortization schedule on a 30-year fixed front-loads interest. During the first year, only 15% of your payments go toward principal. The other 85% goes to interest. That’s why it would take 22 years to pay off half of a 30-year loan at 6.5%.
Some buyers don’t mind foregoing these minimal principal payments when they can borrow more with a 5/1 interest-only ARM. Again, most of these buyers will replace the loan within a few years anyway.
5/1 interest-only ARMs are non-QM loans which mean they aren’t regulated by federal consumer protection laws. To get a 5/1 IO ARM, you’d need to find a lender that offers non-QM loans.
Once you’ve found a lender that offers this kind of financing, you can get a rate quote and start comparing loan offers. Compare rates, but also compare rate caps. They control how much higher your initial rate could go.
It’s hard to find advertised rates for 5/1 interest-only ARMs because mainstream lenders seldom offer this loan type.
An interest-only loan’s initial lower payments can open some doors. You could use the savings to qualify for a larger loan. Or you could put the money you save toward other investments. These loans can be used to purchase or refinance homes.
When the interest-only period ends, the loan will amortize to include principal and interest for the remaining 25 years of the loan. Also, the loan’s interest rate will change based on market conditions at that time.
The second number in a 5/1 or 5/6 ARM shows how often the loan’s interest rate will change after the fixed rate expires. A 5/1 ARM’s rate will change once a year. A 5/6 ARM’s rate will change every six months.
After the 5-year fixed period, principal and interest payments begin and the loan’s interest rate will adjust to market rates. Most ARMs come with rate caps, which limit how far the rate can rise with each adjustment. A loan at a 6.5% start rate might have 2/2/5 caps. In this case, the maximum increase would be 8.5% at the first adjustment, 10.5% at the second adjustment, and a maximum of 11.5% at any time during the loan. This doesn’t mean the loan is guaranteed to rise this much; these are just the limits. It’s even possible that the rate could go down.
Get started on your 5/1 IO ARM?
A 5/1 interest-only ARM is a powerful tool for creating savings and freeing up money to spend elsewhere.
Like any powerful tool, this type of loan needs precision and care. It could backfire if the person using it doesn’t pay attention or doesn’t understand how it works.See how much you can save with a 5/1 IO ARM.