How Do 5/1 ARM Loans Work?

A 5/1 ARM can have significantly lower monthly payments than a fixed-rate mortgage.

A 5/1 ARM home loan is also known as a hybrid adjustable-rate mortgage (ARM). The 5/1 ARM has characteristics of both a fixed-rate and an adjustable-rate mortgage, and offers a fixed payment that is significantly lower, for an initial period of five years, than that of a traditional 30-year fixed-rate mortgage.

Terms

A 5/1 ARM offers a fixed interest rate and level payments for the first five years. After that, it changes to an adjustable-rate loan, with an interest rate that resets every year for the remaining 25 years of the mortgage term. During the adjustable rate years, the interest rate derives from a short-term interest rate index, and can go up or down each year.

Rates

One attractive feature of the 5/1 ARM is that the initial fixed rate is lower than the current 30-year mortgage rate. For example, in mid-November 2010, Wells Fargo Bank was quoting a rate of 4.50 percent for a 30-year conforming mortgage and a rate of 3.125 percent for a 5/1 conforming ARM. A home buyer or refinancing homeowner who selected the 5/1 ARM would lock in this low rate for five years.

Savings

Choosing a 5/1 ARM can result in significant savings. For a $250,000 mortgage at 4.5 percent, the monthly payment would be $1,267. By contrast, a 5/1 ARM rate of a 3.125 percent would require a monthly payment of $1,071 — a savings of almost $200 per month. Over the first five years, a homeowner who selected the 5/1 ARM would save $11,760 in payments, and her mortgage balance would be roughly $5,000 less than if she selected a 30-year fixed mortgage.

Considerations

Home buyers considering a 5/1 ARM must understand how the mortgage will function after initial fixed-rate period ends. The rate for the adjustable period comes from a short-term interest rate index — like the one-year Treasury rate — plus a margin percentage. The home buyer must understand how the lender calculates the adjustable rate, and how rate changes affect monthly payments. The buyer should also confirm that the ARM portion of the loan has annual and maximum interest rate caps.

Warning

The savings offered by a 5/1 ARM might seem very attractive when compared to a fixed-rate mortgage. However, the home buyer must consider what can happen to the monthly payment in year six and beyond. The buyer should ask his loan officer to compute the worst-case interest adjustments for at least two years after the fixed rate expires. If the resulting payment is not affordable, the buyer should reconsider choosing a 5/1 ARM.

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