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If you're looking to buy a home and finance it with a mortgage, you may be seeing different rates for different products, including a 5/1 ARM. But what is a 5/1 ARM? Here, we'll explain how this loan product works and help you decide if it's the right choice for you.
An adjustable-rate mortgage (ARM) is a home loan product that comes with an interest rate that fluctuates over time -- rather than a fixed rate. When you take out a 30-year fixed-rate mortgage, you're guaranteed to keep the same interest rate on your loan for 30 years.
With an adjustable-rate mortgage, the initial rate you lock in will only be guaranteed for a preset period of time. Once that fixed-rate period expires, the interest rate on your loan will adjust once annually -- either up or down.
The first number in an adjustable-rate mortgage is the number of years your initial rate is set for (five years in the case of a 5/1 ARM). And the second number is how often your rate will adjust after that (one year is 1 and six months is 6, for example).
If you take out a mortgage with an adjustable rate, you'll usually get 30 years to pay it off. But during that time, your monthly payment could change based on how your loan's interest rate fluctuates.
A 5/1 ARM is an adjustable-rate mortgage that guarantees you the same mortgage rate and monthly payment for the first five years of your repayment period. Once that five-year period comes to an end, your loan's interest rate can adjust once a year.
If your rate adjusts upward, it will result in a higher monthly mortgage payment. If it adjusts downward, you'll enjoy a lower interest rate and monthly payment on your home loan.
Now the extent to which the interest rate on your 5/1 ARM loan adjusts depends on the benchmark it's tied to. Often, adjustable-rate mortgages are tied to the Federal Funds Rate, which is the rate banks charge each other for short-term loans. When you sign up for a 5/1 ARM, your loan document will tell you what your rate changes will be based on, as well as the maximum amount your rate can rise.
With a 5/1 ARM, you'll often manage to lock in a lower rate than you'll get for a 30-year fixed loan. In some cases, you may get a lower initial 5/1 ARM rate than you'll get with a 20-year or 15-year fixed loan, too. Having a lower interest rate tied to your home loan for five years could make your mortgage payments easier to handle during that time.
Also, while the interest rate on a 5/1 ARM can rise over time, it can also drop, leaving you with a lower mortgage payment than the payment you start out with. If your loan is tied to the Federal Funds Rate and it drops, your rate could shrink as well.
With a fixed mortgage, you're guaranteed the same interest rate throughout your loan term, which means you can look forward to predictable monthly payments. Because a 5/1 ARM can get more expensive once your introductory rate comes to an end after five years, you run the risk of having higher mortgage payments to manage.
A 5/1 ARM could be a good choice under certain circumstances. First, if you're buying a starter home, or a home you don't plan to live in for very long, then it could make more sense to get a 5/1 ARM than a fixed-rate loan. In that case, there's a good chance you'll have moved on from your home before that initial five-year period is up and your rate has a chance to climb.
What's more, while your mortgage rate could rise after five years, if that happens, you can look at refinancing an ARM. In fact, you have a few choices. You can refinance from one ARM loan to another with a lower initial interest rate, or you can refinance from a mortgage with an adjustable rate to one with a fixed rate. In doing so, you can head off a costly rate hike and keep your monthly mortgage costs more affordable.
That said, to qualify for a refinance, you'll need a strong credit score. But if you manage to maintain one, there's less risk with taking out a 5/1 ARM.
As a mortgage borrower, you can choose from many home loan products. If you plan to stay in your home for a long time and want the security that comes with having a fixed rate for the life of your mortgage's repayment period, then a 5/1 ARM may not be a great choice for you. But if you're only planning to live in your home for a handful of years, or you're comfortable taking on the risk that your loan's interest rate might rise, then a 5/1 ARM may allow you to reap savings on your mortgage payments for half a decade (or longer, if your rate drops).
If you're going to get a 5/1 ARM, be sure to shop around for different loan offers. One lender may offer you a lower 5/1 ARM rate than another, so comparing your options with multiple mortgage lenders is a good way to end up with a great deal.
Here are some other questions we've answered:
A 5/1 ARM is a type of mortgage that has an adjustable rate. With a 5/1 ARM, the initial interest rate you secure for your home loan will stay in place for five years. Once that five-year period is over, your loan's interest rate will adjust once a year -- either upward or downward, depending on market conditions.
With a 5/1 ARM, you'll often manage to secure a lower initial interest rate than what a 30-year fixed loan will give you. As such, you'll enjoy a lower monthly payment for at least five years. In some cases, the rate on a 5/1 ARM will adjust downward over time, which means that through the years, you could end up paying even less on a monthly basis for your mortgage loan.
While you may enjoy a lower interest rate on a 5/1 ARM initially, that adjustable rate has the potential to climb. If it does, your monthly mortgage payments will also rise, and they could reach a point where they become less affordable, or not affordable at all. That's a risk anyone who gets a 5/1 ARM must be willing to take.
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