Adjustable-rate mortgages come in several different “flavors.” Generally speaking, they all behave the same. The interest rate on the loan adjusts periodically, at some pre-determined interval. But there are some key differences between them, as well. In this article and video, we will examine the 5-year ARM loan in particular.
Let’s start with the basic differences between fixed- and adjustable-rate mortgages. The rest of the article will make a lot more sense, once you understand this concept. All home loans can be classified as having either a fixed or adjustable interest rate. Here are the key differences between them:
Fixed vs. Adjustable Mortgages
Mortgage lenders charge interest on the loans they make. They do this to make money. It’s the basic concept behind their business model. So they assign an interest rate to each and every loan. The rate will vary from one borrower to the next, based on the person’s credit score, debt-to-income ratio, the type of loan, and other factors. The interest rate is part of what makes up the monthly payment (along with the principal, property taxes and insurance).
A mortgage interest rate can either be fixed or adjustable. When the rate is fixed, it stays the same over the entire life of the loan. You can probably see the benefits of this type of loan. The rate will never fluctuate, so the monthly payments will remain the same size, month after month and year after year. This is true even if you keep the mortgage for the full 30-year term.
In contrast, an adjustable-rate mortgage (ARM) has an interest rate that changes periodically. Generally, the rate will be tied to some kind of index, such as the London Interbank Offered Rate (LIBOR). If the index rate goes up, the ARM loan rate goes up with it. Actually, it’s a bit more complicated than that. But that’s all you need to know in order to understand how the 5-year ARM loan works.
You might wonder why home buyers would use a mortgage loan with an adjustable rate. After all, it does bring a degree of uncertainty into the picture. The number-one reason for choosing an ARM over a fixed-rate mortgage is to secure a lower interest rate. With all other things being equal, the 5-year ARM loans (and other adjustable mortgages) usually have a lower rate than a fixed mortgage.
Of course, this is only true during the initial phase of the ARM. At some point, the interest rate on an adjustable loan will start to change. That’s what the name means, after all. And when it does begin to change, it could eventually exceed the rate you might have secured on a fixed mortgage. In other words, the benefits of using an ARM loan are mostly short-term in nature. Over the long term, you face a lot of uncertainty as to how your rate will change.
How a 5-Year ARM Loan Works: The “Hybrid” Model
Most ARM loans in use today are “hybrid” mortgages. They start off with a fixed interest rate for a certain period of time. This is referred to as the “initial phase.” After that specified period of time, the loan will hit the first adjustment period. This is when the mortgage rate changes. After the first adjustment, the rate will continue to change with some predetermined frequency (usually once a year).
This will make a lot more sense when we examine the 5-year ARM loan. This is actually the most popular type of adjustable-rate mortgage in use today. There are other variations, such as the 1-year and the 7/1 adjustable. But here we will focus on the 5-year version in particular. You might also see it referred to as the 5/1 ARM loan, and you’ll understand why in just a moment.
The 5/1 ARM loan starts off with a fixed interest rate for the first five years. This is where the number 5 comes from in the designation. After the initial fixed-rate period, the interest rate will begin to adjust annually (every year). That’s what the number 1 means in the designation — it means the rate will adjust every year after the initial phase.
So if I take out a 5-year ARM with a 5% interest rate, the rate will stay at 5% for the first five years. After that, the interest rate will begin to adjust (or change) each year thereafter. The interest rate is tied to a certain index, which determines how it changes year after year. We don’t need to go into the definition of an index in this article. Just know that the interest rate on your 5/1 adjustable mortgage will change after the initial / fixed phase, based on certain market conditions.
If you’re thinking about using a 5/1 ARM loan, you need to think about your long-term plans. This is especially true if you plan to be in the home beyond the five-year introductory period. If you plan to sell or refinance the home during the initial fixed-rate phase, then you can avoid the uncertainty of the first adjustment period (provided you can sell or refinance the home).
The Potential for Savings
When you compare the average (initial) interest rate for a 5-year ARM to the average rate for a 30-year fixed mortgage, you can clearly see the potential for savings. Rates for adjustable mortgages are almost always lower than those assigned to fixed mortgages. For example, take a look at the image below.
This snapshot was taken at the time the article was published (Sept. 2011). It shows the average mortgage rates being reported by Freddie Mac, based on their weekly survey of lenders. Notice that the average rate for the 5/1 ARM loan is more than a full percentage point lower than the average for the 30-year fixed-rate mortgage. This is how they usually stack up.
So if I went with the adjustable mortgage, I’d have a smaller monthly payment during the first five years. You can use a mortgage calculator to see exactly how much lower it would be. But after that first five years, my 5-year ARM would begin to adjust. That’s when the uncertainty sets in.
So it’s really a trade-off between the short-term rewards of getting a lower rate, and the long-term risk of adjustment. Like I said, if you are fairly sure you’ll only be in the home for a few years, then a 5/1 adjustable might be a good option for you. If you’re planning to stay in the home for a much longer period of time, you should consider the 30-year fixed-rate mortgage.
This article answers the question: How does a 5-year ARM loan work? If you have additional questions about this topic (or anything else related to the home buying process), try using the search tool at the top of this page. We have hundreds of mortgage-related articles on this website. The search tool is a good way to find the information you need.