Some words about 5/1 adjustable-rate mortgage (ARM)

Many people are wondering what is a 5/1 ARM mortgage? 5/1 ARM is a popular type of 30-year adjustable-rate mortgage; it is a loan that time to time, adjusts its rate. The 5/1 refers to two essential rules for borrowers: fixed mortgage period – the first five years – and one shows how often the interest rate is adjusted annually. Another popular mortgage is 5/6 ARM, which is adjusted every six months after starting.

When does the 5/1 ARM mortgage change?

If we understand what does 5 1 ARM mean, it's time to analyze how to figure out how to pay off such a mortgage.

Countdown starts after taking the 5/1 ARM. If you were to open your credit on June 19, 2022, the first-rate adjustment would occur on June 19, 2027.

When this adjustment occurs, the lender recalculates the interest on your loan depending on how the rate has changed, up or down, which can be higher or lower than the original rate. Exactly one year later, your credit will be adjusted again, and this process will be repeated until the end of the 30 years.

What index does the 5/1 ARM mortgage rely on?

It is not enough to understand what is a 5/1 ARM mortgage; you also need to understand the algorithm for calculating the rate.

The index is a critical factor in determining your pay rate. Previously, ARMs were pegged to either the yield on one-year Treasury bills, the 11th District Value of Funds Index (COFI), or the London Interbank Offered Rate (LIBOR). Instead of LIBOR, a new index is now being used: the Secured Overnight Financing Rate, another name for SOFR.

ARM's mortgage rate will equal the index rate plus the specified margin. For example, in May 2022, SOFR was 1.05 percent. If the margin is three percentage points, the loan rate will equal their sum or 4.05 percent. We hope, now, you comprehend what is 5/1 ARM.

5/1 ARM or 10/1 ARM

ARM 10/1 is a lot like 5/1 ARM loan, except that the starting rate is fixed for ten years instead of five. Typically, a 10/1 interest rate will be slightly higher than a shorter initial period, reflecting the more extended period for which the initial rate is locked.

5/1 ARM vs. 7/1 ARM

ARM 7/1 is the same as ARM 5/1 mortgage, but the actual rate is adjusted after the first seven years, not the first five. The stakes on them will be higher than on 3/1 or 5/1. This longer fixed period is a excellent choice for people who know they want to move or refinance within seven years. The disbursement process is also the same for both types of loans.

Don't forget that the rate resets yearly after the initial fixed period based on the specified index and margin. ARM has a cap on how much the interest rate can rise over the life of the mortgage.

Key advantages and disadvantages of ARM 5/1

After identifying 5/1 ARM meaning it's vital to explain its strengths:

  • Cheaper option: A clear benefit of 5/1 ARM is more affordable monthly payments than a 30-year fixed mortgage. In recent months, ARM interest rates have fluctuated a percentage lower than comparable 30-year fixed loans.

  • Bigger house: A smaller payment allows you to take out a bigger mortgage and get a bigger house or in a better district. It's the main reason why, over the years, the number of people who want to know what's a 5/1 ARM mortgage increased.

  • Could get even more affordable: If interest rates fall, your monthly payment will also go down after the initial period and possibly during future resets.

Now, when we know what is a 5 1 ARM mortgage, we also understand that this solution also has some drawbacks:

  • It could cost you a lot more: the big downside of 5/1 ARM is exposure to higher rates after the fixed period expires. If rates go up, your payment will go up.

  • Complexity: Adjustable mortgages have more moving parts than fixed mortgages. It can all be technical for the average homeowner rate caps, indexes, and resets.

  • Expensive refinancing. When the rate increases, it is technically possible to refinance or replace your 5/1 ARM loan with a new loan. Unfortunately, refinancing your mortgage, in this case comes with colossal closing costs that can be as high as six percent of the amount you owe.

  • Interest-only trap: some ARMs let to pay only interest, not principal, in the initial period. It may allow you to increase your budget and lower your payment, but after the fixed period, your payments will be much higher, including the principal. If the value of your home falls, you may find yourself in a difficult situation because of a loan.

Before taking a mortgage, you must read 5 1 ARM mortgage definition, and analyze all the pros and cons.