By Brian O’Connell
Original post at SoFi and has been reposted with permission.
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Mortgage shoppers have multiple options, including the adjustable-rate mortgage (ARM). Is a 5/1 ARM a good choice? A lot depends on how long borrowers plan to keep the property and whether they can cover higher mortgage payments if interest rates go up.
While most borrowers will opt for a conventional 30-year fixed-rate mortgage, some may decide that an adjustable-rate loan is a better fit.
Recommended: Understanding the Different Types of Mortgage Loans
Here’s a closer look at ARMs and the 5/1 ARM in particular.
Anatomy of an ARM
An adjustable-rate mortgage often has a lower initial interest rate—for as little as six months to as long as 10 years—than a comparable fixed-rate mortgage.
Then the rate “resets” up (or, sometimes, down) based on current market rates, with caps dictating how much the rate can change in any adjustment.
With most ARMs, a rate adjustment happens once a year. And ARMs are usually 30-year loans.
What Is a 5/1 ARM?
You’ll see adjustable-rate mortgage loans typically come in the form of a 3/1, 7/1, and 10/1, but the most common is the 5/1 ARM.
With a 5/1 ARM, the interest rate is fixed for the first five years of the loan, and then the rate will adjust once a year—hence the “1.”
Adjustments are based on current market rates for the remainder of the loan.
5/1 ARM Rates
An ARM interest rate is made up of the index and the margin. The index is a measure of interest rates in general. The margin is an extra amount the lender adds, and is usually constant over the life of the loan.
Caps, or limits, on how high (or low) your rate can go will affect your payments.
Let’s say you’re shopping for a 5/1 ARM and you see one with 3/2/5 caps. Here’s how the 3/2/5 breaks down:
• Initial cap. Limits the amount the interest rate can adjust upward the first time the payment adjusts. In this case, the first adjustment, after five years, can’t be higher than 3%.
• Cap on subsequent adjustments. In the example, the rate can’t go up more than 2% with each adjustment after the first one.
• Lifetime cap. The rate can’t go up more than 5% for the life of the loan.
A mortgage payment spike after a rate adjustment can lead to payment shock.
Then again, a 5/1 ARM borrower may be able to save significant cash over the first five years of the loan.
Let’s say a borrower has a choice between a 30-year fixed-rate mortgage loan and a 5/1 ARM. Here’s the difference between the two loans after five years, using hypothetical interest rates, based on a loan amount of $300,000.
The 30-year fixed-rate loan has a rate of 3.8%, a monthly payment of $1,398 (not including taxes, insurance, or closing costs), and a total loan payout of $83,820. The remaining loan balance after five years is $270,456.
A 5/1 ARM has an initial interest rate of 3.0%, a monthly payment of $1,265, and a total loan payout of $75,840. The borrower owes $266,719 after five years.
Over the initial five-year period, the 5/1 ARM borrower would save the following:
Monthly savings = $133.00
Five-year savings = nearly $8,000
Of course, that represents only five years of a typical 30-year mortgage loan.
5/1 ARM Loan Pros and Cons
Borrowers should be aware of all the upsides and downsides of adjustable-rate mortgages.
5/1 ARM Pros
A lower interest rate upfront.
The initial five-year mortgage period usually comes with a lower interest rate than a fixed-rate mortgage. This can be an advantage for new homeowners who lack the cash needed to furnish the home and pay for landscaping and maintenance. And first-time homebuyers may gravitate toward an ARM because lower rates increase their buying power.
Potential for long-term benefit. If interest rates dip or remain steady, an ARM could be less expensive over a long period than a fixed-rate mortgage.
Could be good for short-term homeowners. Some buyers may only need a home for five years or less (for example, business professionals who think they’ll move or be transferred). These borrowers may get the best of both worlds with a 5/1 ARM: lower interest rates and no risk of much higher rates later on, as they’ll likely sell the home and move before the interest rate adjustment period kicks in.
5/1 ARM Cons
Risk of higher long-term interest rates. The good fortune with a 5/1 ARM runs out after five years, when the likelihood of higher interest rates increases. The loan could eventually reset to a rate leading to loan payments the borrower finds uncomfortable or unaffordable.
Higher overall home loan costs. As interest rates rise with a 5/1 ARM, homeowners will likely pay more over the entire loan than they would have with a fixed-rate home loan.
Refinancing fees. You can refinance an ARM to a fixed-rate loan, but you can also expect to pay some significant fees. Typically, mortgage loan refinancing costs 3% to 6% of the total cost of the loan.
Possible prepayment penalty. Some ARMs require special fees or penalties if you refinance or pay off the ARM early (usually within the first three to five years of the loan). And some loans have prepayment penalties even if you make only a partial prepayment.
Possible negative amortization. Some loans have payment caps. Payment caps limit the amount of payment increases, so payments may not cover all the interest due on your loan. The unpaid interest is added to your debt, and interest may be charged on that amount. You might owe the lender more later in the loan term than you did at the start. Be sure you know whether the ARM you are considering can have negative amortization, the Federal Reserve advises.
Recommended: How To Avoid Paying a Prepayment Penalty
Is a 5/1 ARM Right for You?
Is a 5/1 ARM loan a good idea? It depends on your finances and goals.
In general, adjustable-rate mortgages make more sense when there’s a sizable interest rate gap between ARMs and fixed-rate mortgages. If you can get a great deal on a fixed-rate mortgage, an adjustable-rate mortgage may not be as attractive.
If you plan on being in the home for a long time, then one fixed, reliable interest rate for the life of the loan may be the smarter move.
As the Fed says, an ARM presents a trade-off: You get a lower initial rate in exchange for assuming more risk over the long run. The advantages must be weighed along with the risk that an increase in interest rates will lead to higher monthly payments in the future.
Your best bet on ARMs? More tips from the Fed:
• Talk to a trusted financial advisor or housing counselor.
• Get information in writing about each ARM program of interest before you have paid a nonrefundable fee. • Ask the lender or broker about anything you don’t understand, such as index rates, margins, caps, and negative amortization.
• If you apply for a loan, you will get more information, including the annual percentage rate (APR) and a payment schedule, and whether the loan has a prepayment penalty. The APR takes into account interest, points paid on the loan, any fees paid to the lender, and any mortgage insurance premium. You can compare APRs on similar ARMs and compare terms.
• Shop around and negotiate for the best deal if you’ve chosen to take out an adjustable-rate mortgage.
A 5/1 ARM offers borrowers a temporary perk, but they assume risk over the long run. Tempted by a sweet introductory rate? It’s a good idea to go in with eyes wide open about rate adjustments, prepayment penalties, and your homeownership goals.
If one sweet fixed rate from here to eternity—well, up to 30 years—sounds good, SoFi offers fixed-rate home loans as well as mortgages for second homes and investment properties.
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