Definition of a 5-year ARM
A 5-year ARM (adjustable rate mortgage) is a mortgage loan that has a fixed interest rate for the first 5 years of the loan. After that initial period, the interest rate of the loan can change (adjust) once each year for the remaining life (term) of the loan. This term is typically 30 years.
This type of loan is often listed or displayed as a 5/1 ARM. This indicates that the mortgage has a fixed rate for the first five years and then an adjustable rate every (1) year thereafter. This is very important to understand because as a result of this adjustable rate, the monthly payment may change from year to year after the first five years.
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The 5 Year Arm or 5/1 ARM is considered a hybrid mortgage. This means that the loan combines the features of a fixed-rate mortgage (the first five years) and an adjustable rate mortgage (for the remaining years).
Generally, an adjustable rate mortgage gives you a lower rate than a fixed-rate longer term (30 or 15 year) loan. This is because the lender is only hedging against interest rates over a shorter period of time. As a result, a borrower can often get a lower payment over some fixed period of time, in this case 5 years.
Depending on financial and housing goals borrowers that choose adjustable rate loans anticipate one of a few future scenarios–increasing personal income, refinancing or selling the home before the rate adjusts, or interest rates to go lower in the future.
Typically, an ARM is structured with the following basic features:
Initial interest rate: This is the beginning interest rate on the ARM. It is often a fixed percentage rate for a period of time. In the case of the 5/1 ARM, this initial interest rate is fixed for a period of five years and then it enters into the adjustment period.
Adjustment period: This is the length of time that the interest rate is to remain unchanged. For example, in the case of a 5/1 ARM the initial adjustment period is five years and then after that it is every year until the loan is paid off. At the end of each period the rate is reset and the monthly loan payment is recalculated.
Index rate: Most ARMs are tied to an “index rate.” This is a benchmark by which they determine what the new rate will be adjusted to at the end of each adjustment period. The most common index used for mortgages is the one-year LIBOR (London Interbank Offered Rate),
Margin: This is the percentage points added to the index rate to determine the ARM’s interest rate. For example, an ARM’s interest rate = index rate + margin.
Interest rate cap: Typically, ARMs have limits on how much interest rates can change at any adjustment period or over the life of the loan (often both). This is an important risk mitigating factor that you should always closely review if you consider an ARM.
Some additional special features (many of which are discouraged by regulation):
- Initial discounts (teaser rates): Some ARM loan programs contain initial interest rate “concessions” that are below the prevailing interest rates on a comparable loan. These discounts are offered as promotional or incentive enticements for some initial period of the loan.
- Negative amortization: When a loan goes into negative amortization it means that the loan’s balance is actually increasing. Typically, this is the result of the payment cap or requirement being less than the principal and interest payment.
- Conversion: Some ARMs have a special provision that allows for the borrower to convert the ARM to a fixed-rate mortgage at designated periods during the life of the loan.
- Prepayment: Some ARMs may have special fees or penalties if the mortgage is paid off early–prior to the full term of the loan.