A 5/1 adjustable-rate mortgage (ARM) is a hybrid mortgage with a super-low introductory rate that's often lower than what you'd find on a fixed-rate mortgage. This 5-year ARM teaser rate is just that -- a teaser. After that initial five-year period, your ARM's interest rate will start adjusting every six months based on changes in mortgage indexes. The margin, which is the difference between the index and your actual mortgage rate, remains the same throughout the life of your loan.
The 5/1 ARM is a hybrid mortgage because it has a fixed-rate period and an adjustable-rate period. During that first five years, you'll enjoy a fixed interest rate. After that, your 5/1 ARM's interest rate will begin adjusting every six months based on the movements of mortgage indexes. There are caps on how much your rate can change at each adjustment and over the life of the loan.
You'll often see 5/1 ARM caps listed in a set of three numbers, like 2/1/5. Here's what those numbers mean:
- Initial cap. The first number represents how much your interest rate can increase the first time it adjusts. In our 2/1/5 example, that's 2 percentage points. If you started out with a 3.5% interest rate, the highest your first adjustment could bring is 5.5%.
- Subsequent/periodic cap. The middle number is the amount your interest rate can change each time it adjusts after that first reset. With a 2/1/5 ARM, your rate can increase by 1 percentage point every six months. Continuing the example, if you're at 5.5% — the highest your first adjustment could bring you — the highest you could go from that is 6.5%.
- Lifetime cap. The last number gives you the highest that your interest rate could go above your initial rate. Five percentage points are pretty common. With our 2/1/5 example, assuming you'd started out with a 3.5% introductory rate, your lifetime cap would be 8.5%.
Knowing these different caps can help you understand what could happen if you end up keeping your 5/1 ARM beyond that initial five years. You can also ask ARM lenders to do the math for you and give you actual numbers for what your mortgage payment could be at different interest rates.
Depending on prevailing rates, your interest rate also could adjust downward. This actually can put ARM borrowers in the adjustable period at an advantage, because in a falling rates environment they can get an interest rate decrease without having to refinance. However, lenders may set a floor limiting how much your interest rate can fall if rates are going down. What are the disadvantages of a 5/1 ARM? Adjustable-rate mortgages, including the 5/1 ARM, aren't a fit for every home buyer. Here are some of the drawbacks of 5/1 ARMs.
- Less predictability. Even knowing the caps and the floor, you don't know exactly what your monthly mortgage payment will be after the introductory period ends. You might have decided during that five years that you absolutely love the house and no longer want to move — and if your budget can't accommodate the rate increases, that could be a problem.
- Expensive to leave. If you're planning to move anyway, no big deal. But if you need to refinance to a fixed-rate loan or into a new ARM, you'll have to factor in the cost of refinancing. Refinance closing costs can come to 2% to 5% of the loan costs, which could potentially cancel out the savings from your introductory rate.
» MORE: Compare 3- and 7-year ARMs
Features
Introductory Rate Period. The initial five years of a 5-year ARM feature a fixed "teaser" interest rate, which is typically lower than prevailing rates on fixed-rate mortgages. This can make early monthly payments more affordable.
Adjustment Frequency. After the first five years, the interest rate adjusts every six months. This adjustment is based on an index plus a fixed margin, reflecting current market conditions.
Interest Rate Caps. Caps are in place to limit how much the interest rate can change. The initial cap restricts the first adjustment, the periodic cap limits subsequent adjustments, and the lifetime cap sets the maximum possible rate increase over the loan's term.
Margin and Index. The loan's interest rate consists of a fixed margin and a variable index. While the margin remains constant, the index can fluctuate, impacting the overall interest rate.
Hybrid Nature. Combines a fixed-rate period with a subsequent adjustable-rate period, offering a mix of stability and flexibility. The fixed period allows for planning, while the adjustable period adapts to market conditions.
Pros and Cons
- A 5/1 ARM can be a great choice if you're looking to buy a home in the near future but know you won't be staying in your first home long term. You'll get the benefits of a super-low introductory rate, and if you decide to move before the ARM adjusts, you won't have to worry about it.
- Super-low introductory rate. A 5/1 ARM's introductory rate is often lower than what you'd find on a 7/1 or 10-year ARM, and sometimes even lower than what you'd find on a 30-year fixed-rate mortgage. This is because the ARM's fixed-rate period is shorter.
- Could be all the loan you'll need. If you're planning on moving in less than five years, you'll get the interest rate advantages of an ARM's fixed period but never even deal with the adjustable portion of the loan. As long as you stick with that plan, you could save over buying the same home with a different loan type. If this is your forever home, however, another kind of mortgage might make more sense.
- More time to pay down principal. For the five years when you've got that low interest rate, you could use any "extra" money to aggressively pay down your principal. When the ARM resets, or when you decide to refinance, you'll have a smaller mortgage balance. If you stick with the ARM, you're paying interest on a smaller sum. Choose to refi, and your closing costs — which, again, can be 2% to 5% of the loan amount — will be lower, since you
- Super-Short Fixed Rate. A 5-year ARM's fixed-rate period is the shortest of any hybrid mortgage. After that, your interest rate can change, and your monthly payment could skyrocket.
- Adjustable-Rate Risk. The adjustable period on a 5-year ARM can last up to 23 years, which is a long time for your interest rate to be at the mercy of the market. Even with caps, there's a good chance your rate and payment will increase at some point.
- Costly exit. If you're stuck with a 5/1 ARM and your payment becomes unaffordable, you'll need to refinance to a new loan to get a fixed rate again. Refinance closing costs can be 2% to 5% of the loan amount, which could erase some or all of the savings you've enjoyed during the ARM's introductory 5 years.
How to Get an ARM with a 5-Year Term
Assess Your Financial Health. Obtain a copy of your credit report and check your credit score. Most mortgage lenders require a minimum credit score for approval. Calculate your DTI by dividing your monthly debt payments by your gross monthly income. Lenders typically prefer a DTI of 43% or lower. Aim to save at least 20% of the home's purchase price to avoid private mortgage insurance (PMI), though some lenders offer options with lower down payments.
Determine Your Budget. Use a mortgage calculator to estimate your monthly mortgage payment based on various loan amounts, interest rates, and down payment sizes. Factor in property taxes, homeowners insurance, mortgage insurance, and potential homeowners association (HOA) fees.
Get Pre-Approved. Research mortgage lenders, including banks, credit unions, and mortgage brokers, to find one that offers favorable terms and rates. Provide necessary documentation, such as proof of income, tax returns, and bank statements, to the lender for pre-approval. A pre-approval letter indicates the loan amount you qualify for, which can strengthen your offer when buying a home.
Shop for a Mortgage. Obtain quotes from multiple lenders to compare interest rates, loan terms, and fees. Adjustable-rate mortgages (ARMs) have variable rates that may start lower but can increase over time. The APR includes the interest rate and additional fees, providing a more comprehensive view of the loan's cost.
Choose Your Mortgage. Consider the interest rate, loan term, monthly payment, and any additional costs or fees when choosing the best mortgage offer. Once you’ve chosen a mortgage, you may have the option to lock in the interest rate to protect against rate increases before closing.
Complete the Application. Provide detailed information about your financial situation, employment, and the property you wish to purchase. Some lenders charge fees to process your application.
Go Through the Underwriting Process. Be prepared to submit further documentation as requested by the lender during underwriting. The lender will order an appraisal to ensure the property’s value supports the loan amount. A title company will verify the property’s title to ensure there are no legal issues.
Close on Your Mortgage. This document outlines the final terms of your loan, including the loan amount, interest rate, monthly payments, and closing costs. Review it carefully. Sign the necessary documents to finalize the loan. Bring a cashier's check or arrange a wire transfer for your down payment and closing costs. Once all documents are signed and funds are transferred, you’ll receive the keys to your new home.
Requirements
Credit Score. A minimum score of 620 for conventional loans. Higher scores may be required for better rates or specific lenders.
Down Payment. Typically 5% to 20% of the home’s purchase price, depending on lender policies and borrower’s credit profile.
Debt-to-Income Ratio (DTI). Generally, lenders prefer a DTI of 36% or lower. Some lenders may accept up to 43%, especially with compensating factors.
Income Verification. Proof of stable and sufficient income through pay stubs, tax returns, and bank statements.
Employment History. At least two years of steady employment, preferably in the same field.
Savings/Reserves. Proof of adequate savings or reserves, often required to cover a few months of mortgage payments.
Property Appraisal. The home must be appraised to verify its value meets or exceeds the purchase price or loan amount.
Other Documentation. Government-issued ID, Social Security number, and authorization for credit checks. Documentation of other assets and liabilities.
Conditions
Introductory Rate. Fixed interest rates for the initial five years, often significantly lower than fixed-rate mortgage rates. Example: 3.5% for the first five years.
Adjustment Frequency. After the initial fixed period, the interest rate adjusts every six months based on the index plus a fixed margin.
Interest Rate Caps. The initial cap is typically, the first adjustment that can increase the rate by up to 2 percentage points. Each subsequent adjustment can increase the rate by up to 1 percentage point. The interest rate can increase by no more than 5 percentage points over the life of the loan.
Margin. A fixed amount is added to the index rate to determine the new rate at each adjustment. Example: 2.5%.
Index. The variable part of the interest rate, can be tied to indices like the LIBOR, SOFR, or Treasury rates.
Loan Term. Typically a 30-year loan term, with the first 5 years at a fixed rate and the remaining 25 years adjustable.
Teaser Rates. The introductory rate (teaser rate) is set lower to attract borrowers during the fixed-rate period.
Down Payment. Lenders may require down payments as low as 3% for conventional loans, while borrowers aiming to avoid private mortgage insurance (PMI) may opt for down payments of 20% or more.
Loan Amounts. Lenders may offer mortgage loans ranging from $100,000 to $1,000,000 or more, depending on the borrower's financial profile and the property's value.
Ways to Get the Money
Certified Check. Some borrowers may choose to receive mortgage funds in the form of a certified check issued by the lender or closing agent. This method provides a physical form of payment that can be deposited into the borrower's bank account.
Escrow Disbursement. In some cases, mortgage funds are held in an escrow account and disbursed to the appropriate parties at closing. This method ensures that all closing costs and fees are paid before releasing the remaining funds to the borrower.
Direct Deposit. Certain lenders offer the option for mortgage funds to be directly deposited into the borrower's bank account on the day of closing. This electronic transfer provides immediate access to the loan proceeds without the need for physical checks or wire transfers.
Things to Pay Attention To
Interest Rate and APR. Compare both the interest rate and the annual percentage rate (APR) to understand the total cost of the loan, including fees and other charges.
Loan Term. Consider the length of the loan term and how it affects your monthly payments and total interest paid over time.
Type of Mortgage. Determine whether a fixed-rate or adjustable-rate mortgage (ARM) is more suitable for your financial situation and long-term goals.
Down Payment Requirements. Understand the minimum down payment required by the lender and consider how it impacts your upfront costs and monthly payments.
Closing Costs. Review the breakdown of closing costs, including appraisal fees, title insurance, and origination fees, and ensure they align with your budget.
Prepayment Penalties. Check if the mortgage includes penalties for paying off the loan early and consider whether this aligns with your plans for the property.
Private Mortgage Insurance (PMI). Understand if PMI is required for your loan and how it affects your monthly payments, especially if you're making a down payment of less than 20%.
How to Repay an ARM with a 5-Year Term?
Understand Your Mortgage Terms. Familiarize yourself with the terms of your mortgage, including the interest rate, loan amount, loan term, and any prepayment penalties or other fees. Determine the frequency of mortgage payments (e.g., monthly, bi-weekly) and the due date for each payment.
Set Up a Payment Method. Consider setting up automatic payments through your bank or mortgage servicer to ensure timely payment each month. Explore online payment options provided by your lender or servicer for convenience and ease of use. If preferred, you can also mail payments to the address provided by your lender, ensuring they are received by the due date.
Consider Additional Payments. Determine if you can make extra payments towards your mortgage principal to pay down the loan faster and save on interest. Explore the option of making bi-weekly payments instead of monthly payments to accelerate the repayment schedule.
Communicate with Your Lender. Keep your lender informed of any changes to your financial situation that may impact your ability to make mortgage payments. If you encounter financial hardship, such as job loss or medical expenses, contact your lender to discuss potential options for assistance or loan modification.
Reasons for Getting Rejected for an ARM with 5-Year Term
Low Credit Score. A history of late payments, defaults, or high levels of debt can lower your credit score, making you a higher risk for lenders. Multiple recent credit inquiries or applications for new credit may signal financial instability to lenders.
High Debt-to-Income Ratio (DTI). Lenders assess your DTI ratio, which compares your monthly debt payments to your gross monthly income. A high DTI ratio may indicate that you are overleveraged and unable to afford additional debt.
Insufficient Income. Lenders require proof of stable income to ensure you can afford mortgage payments. Inconsistent or insufficient income documentation may result in rejection. A short or unstable employment history can raise concerns about your ability to maintain a steady income for mortgage payments.
Inadequate Down Payment. Lenders typically require a minimum down payment, often around 20% of the home's purchase price. A smaller down payment may result in higher risk for the lender and increase the likelihood of rejection.
Poor Property Appraisal. If the appraised value of the property is lower than the purchase price or loan amount, lenders may hesitate to approve the mortgage due to concerns about the property's value as collateral.
Unstable Financial History. Past bankruptcies, foreclosures, or other negative financial events may raise red flags for lenders and result in mortgage rejection. Outstanding collections accounts, tax liens, or other financial judgments can signal financial instability and impact your ability to qualify for a mortgage.
Alternatives
A personal loan is an unsecured loan that can be used for various purposes, including home renovations or purchases. Personal loans typically have fixed interest rates and repayment terms, providing predictability for borrowers. While not secured by the property, personal loans may have higher interest rates compared to mortgages.
With a lease-to-own agreement, you rent a home with the option to purchase it at a later date. A portion of your monthly rent payments may go toward the purchase price, providing an opportunity to build equity over time without committing to a mortgage upfront.
Some retirement plans, such as 401(k)s, allow participants to borrow against their account balance for various purposes, including home purchases or renovations. 401(k) loans typically have lower interest rates compared to other credit products and may not require a credit check. Borrowers must repay the loan according to the plan's terms or face penalties and taxes.
A bridge loan is a short-term loan used to bridge the gap between the purchase of a new home and the sale of an existing property. Higher interest rates and fees compared to traditional mortgages, typically repaid within a few months to a year and secured by the borrower's existing home. Provides temporary financing for homebuyers facing timing challenges, such as contingent offers or overlapping mortgage payments.
Editorial Opinion
A 5-year term adjustable-rate mortgage (ARM) can be a great option if you want a super-low introductory interest rate to save on your purchase loan. The 5-year ARM ARM is a popular choice since the introductory rate is so much lower than a fixed-rate mortgage. You'll get a "teaser" rate for the first five years, which is perfect if you plan to be house-poor for a few years. However, when that 5-year mark comes around, your interest rate will adjust to an floating rate. This means it can go up or down depending on economic conditions and the value of other instruments, like the secured overnight financing rate. If rates fall, you'll benefit from a lower interest rate. But if rates rise, your payment could increase significantly. You'll want to carefully consider your financial situation and how it may change over the life of a 30-year mortgage before choosing a 5-year ARM. Can you refinance or sell your home before the adjustment period? If not, a different loan type might be a better fit.
Important
Keeping your Debt-to-Income (DTI) ratio below 30-40% of your monthly income is crucial. This will help you avoid potential financial problems in the future. Additionally, always assess the necessity and feasibility of taking a loan, ensuring you can comfortably manage its repayment.
How to Choose a Mortage Lender
Check Associations. Look for lenders who are members of reputable organizations, such as the Mortgage Bankers Association (MBA). Membership in these organizations can indicate a higher level of reliability and professionalism.
Review Terms and Conditions. Carefully examine all the terms and conditions of the mortgage contract. Pay special attention to details like the loan term, fixed vs. variable interest rates, and any prepayment penalties.
Interest Rates and Costs. Scrutinize the interest rates and ensure that your contract includes a detailed breakdown of the total cost of the mortgage, including closing costs, origination fees, and any other charges.
Right of Rescission. Remember you can utilize your right of rescission, which typically allows you to cancel the mortgage within three days after signing the agreement. Additionally, use the "cooling-off" period to thoroughly review the contract and make an informed decision before finalizing the mortgage agreement.
Compare Offers. Shop around and compare offers from multiple lenders to find the best rates and terms that suit your financial situation.
Additional resources
To learn more about mortgages and best practices, check out some of the following resources: