5/1 ARM Explained: Pros and Cons of a 5/1 ARM Loan

A 5/1 ARM is an adjustable-rate mortgage loan that offers home buyers a fixed interest rate for the first five years of the loan term. After that five-year fixed period of time is up, the 5-year ARM rate increases to a variable rate based on market conditions.

The interest rate of a 5/1 ARM home loan may increase over the life of the loan (typically 15, 20, or 30 years total), but it comes with certain protections for borrowers. The Federal Housing Authority (FHA) stipulates that mortgage lenders can only perform one rate adjustment per year. This loan type also comes with a lifetime cap on rate changes. And while this type of mortgage typically produces higher interest rates after the introductory period, it can also adjust to a lower interest rate, depending on market trends in real estate lending.

First-time homeowners looking to build up home equity can benefit from a 5/1 ARM mortgage, provided that they take full advantage of the low rate during the initial period. The clear benefits of the 5/1 ARM loan product are:

1. 1. Low initial interest rate: The 5/1 ARM loan product comes with a low mortgage interest rate at the beginning of the contract. During this introductory rate period, homeowners can expect a lower monthly mortgage payment than might come with a fixed-rate mortgage.
2. 2. Good for short-term ownership: If you plan on flipping your home or selling it during the first five years of ownership, you may never have to deal with the variable interest rates that come later in the loan contract. You can take advantage of low monthly payments for a few years and be on to your next house before higher interest rates kick in.
3. 3. Easier to pay down principal early: In home buying, your loan amount is the principal you owe, or the price of the house you agreed to when buying it from the seller. You immediately pay off some of this principal with your down payment, but the remaining amount is subject to interest. The low rates at the beginning of a 5/1 ARM mortgage may allow you pay off more of the principal early. That way, when higher rates kick in, you'll be paying interest on a lower base number.

While a 5/1 ARM can fit some home buyers' needs, such mortgages are not for everyone. A few key drawbacks include:

1. 1. Not ideal for long-term homeownership: If you plan to stay in your newly purchased home for many years, you may pay less interest with a long-term fixed-rate mortgage. The savings you get from a 5/1 ARM all come in the first five years of ownership, but those savings may dwindle over time as rates go up. A fixed-rate mortgage is steady and more predictable year to year.
2. 2. Expensive refinancing: It is technically possible to refinance—or replace your 5/1 ARM loan with a new loan—when the rate increases. Unfortunately, a mortgage refinance in this case comes with hefty closing costs, which can be as high as six percent of the amount you owe.
3. 3. Unpredictability: After five years, the 5/1 ARM becomes an adjustable-rate mortgage, and such loan products can provide unpleasant surprises to borrowers. If your mortgage rate spikes and you can't pay your monthly payments on time, your credit score will suffer. If you stop paying altogether, you risk losing your home.

A 7/1 ARM loan functions in the same way as a 5/1 ARM loan. Both loan options begin with a fixed-rate mortgage that then becomes variable after a number of years. The origination process is also the same for both loan types, but there are two key differences.

• Fixed-rate term: A 5/1 ARM keeps a fixed rate for five years before shifting to an adjustable-rate mortgage (that comes with a rate cap). With a 7/1 ARM, the fixed-rate loan expires after seven years.
• Rate savings: A 5/1 ARM offers a lower initial mortgage rate than a 7/1 ARM. While borrowers enjoy two extra discounted years under a 7/1 ARM, such savings will be more modest from year to year compared to a 5/1 ARM.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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