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One of the ways to save on interest, at least at the start of your mortgage, is to get a 5/1 Variable Rate Mortgage (5/1 ARM). With an ARM 5/1, you get a fixed rate for the first five years of your mortgage, with the rate being adjusted each year thereafter.
A 5/1 ARM can help you get a lower interest rate upfront, which can make it attractive to some homebuyers.
Here’s what you need to know about ARM 5/1 loans:
What is an ARM 5/1 loan?
A 5/1 ARM is a type of hybrid mortgage that includes a fixed rate for a specified period before moving to an adjustable rate.
Here’s what the two numbers say:
- The first issue: The number of years your interest rate remains fixed.
- The second issue: The frequency with which the rate will adjust annually after this fixed period.
For example, if you had an ARM 5/1 with a term of 30 years, you would have a fixed interest rate for the first five years. After that, you would see your rate and payment change once a year for the remaining 25 years.
Learn more: What is a mortgage rate and how do they work?
How an ARM 5/1 works
An ARM 5/1 loan works by starting with a fixed interest rate and later moving to an adjustable interest rate. Your rate is fixed for five years, then each year thereafter the rate will increase or decrease according to market rates.
There are usually caps on the level to which the interest rate can adjust. Each time your rate adjusts, your payment will adjust as well, to make sure you pay back your mortgage on time.
Here’s an overview of how ARM 5/1 works:
Your adjustable interest rate is based on a specific index and margin. Each year your lender will review the index specified in your documents and add the required margin to it – this will be your new rate for the coming year.
Here is a quick description of what Index and Margin are and how they work:
- Index: The benchmark interest rate based on current market conditions. In the past, many mortgages used the London Interbank Offered Rate (LIBOR), but this is being phased out in favor of the Guaranteed Overnight Finance Rate (SOFR). Other indices could be taken into account, in particular the Cost of Funds Index (COFI) and the Constant Maturity Treasuries (CMT).
- Margin: This is the fixed amount added to the index by your lender, giving you your interest rate for the year. For example, if you have a 3% margin and your rate adjusts for SOFR – and SOFR is 0.15% – your new mortgage rate would be 3.15%.
Interest rate caps
The good news is that your mortgage interest adjustment is limited. So you won’t see your rate going up out of nowhere.
In many cases, a lender will issue a cap based on the first adjustment, subsequent adjustments, and a lifetime cap. A common cap is the 2/2/5 cap. here is how does this ceiling structure work:
- Initial setting cap: The first number represents the initial adjustment limit. This is the first time that the lender has changed the rate after the end of the fixed rate. So in this case, the rate cannot be more than two percentage points higher than your initial rate, regardless of the amount. interest rate increased.
- Subsequent adjustment limit: The second number reflects the cap on subsequent adjustments. Again, in this case, the adjustment cannot exceed two percentage points.
- Lifetime ceiling: The final number indicates the lifetime cap. As long as you have the loan, the interest rate cannot exceed five percentage points above your initial rate if you have a 2/2/5 cap.
ARM 5/1 generally have an overall duration of 15 or 30 years. The interest rate remains fixed for the first five years and then adjusts each year for the remainder of the loan.
To see what your monthly payment would be at a certain interest rate, use the calculator below.
Enter your loan information to calculate how much you could pay
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interest over the life of your loan. You will pay a total of
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To get a better idea of what you would pay each month (principal and interest only) with an ARM 5/1 versus a fixed rate mortgage, let’s take a quick example.
Advantages and disadvantages of an ARM 5/1
The low initial interest rate on a variable rate mortgage makes it an attractive option and could make buying a home more affordable for you.
But you will need to be comfortable with the uncertainty. If rates go up, you could end up with a higher mortgage payment and having to pay more interest in the long term.
- Lower initial interest rate: With a lower interest rate to start with, you’ll benefit from a lower mortgage payment during the first few years of your loan. Knowing this, you can use the difference to invest, pay off the principal, or make improvements to the home.
- Could end up paying less interest: As long as rates stay low, you may be able to save on interest. Also, if you take the difference in payment amount from a fixed rate loan and apply it to principal, you reduce the balance you are paying interest on.
- Can be beneficial if you know you will be moving soon: If you know you’ll be moving in five years, before the rate adjusts, you could save money. When you know you’re not staying in the house, you can make the appropriate adjustments and save on monthly cash flow and interest.
- Potentially higher mortgage payment: If rates go up, your mortgage payment will go up too. After the initial period, you may see an increase in payments, up to the cap. If so, it could cause problems for your monthly budget.
- Could pay more interest over the life of the loan: If rates tend to go up, over time you could end up paying more interest overall, even with a cap rate.
- The difference in rates might not be worth it: If there isn’t a big difference between the interest rate on a fixed rate loan and that on an ARM, the slightly higher upfront payment with a fixed rate loan might be the better choice. Especially since refinance your mortgage may add additional costs if you decide to upgrade to a fixed rate loan at a later date.
Credible can be of great help when trying to find a good interest rate. You can easily compare our partner lenders and see prequalified rates in as little as three minutes, all without leaving our platform.
When to consider an ARM 5/1
Going for an ARM 5/1 makes sense if you don’t plan on living in your home for the long term. If you intend to sell the house within five years, you can take advantage of the lower initial fixed interest rate of the ARM and a lower initial monthly payment.
If you stay home for five years or more, an MRA is riskier. Since the rate can fluctuate, you could end up with a higher interest rate and a minimum monthly payment.
If you decide to refinance before the end of the fixed term, be aware that you may have to pay refinancing closing costs this could offset savings resulting from lower interest and lower payments.