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Reader question: “We have been watching mortgage rates for some time, because we are in the market for a home loan. We are first-time buyers with good credit and two good jobs between us. I’ve noticed that interest rates for the 5/1 ARM loans are typically much lower than the rates for 30-year fixed loans. So we are leaning toward the 5-year adjustable to keep our monthly payments down. I’m just wondering if this is a good strategy for first-time buyers like us. Is a 5-year ARM loan a good or bad idea for someone in our situation?”
The 5-year adjustable-rate mortgage loan is a good idea in certain scenarios, and a less wise choice in other situations. It mostly depends on your long-term plans and your appetite for risk. If you want to save money during the first few years, and you’re not concerned what happens beyond that (for whatever reason), then a 5/1 ARM loan might be a good option for you.
Definition: The 5/1 adjustable-rate mortgage (ARM) is a “hybrid” loan that acts like two different products rolled into one. For the first five years, it behaves like a fixed-interest loan because the rate stays the same during that period. But after that initial phase, this type of ARM will undergo a rate adjustment every year. That’s what the “5/1″ numbers indicate.
So, when does it make sense to use this kind of mortgage product? Let’s talk about that next.
Is the 5-Year ARM a Good Idea for Your Situation
Is the 5-year hybrid ARM loan a good choice for you? Here are some questions you need to ask yourself:
- How long do you plan to stay in the home? If you plan to stay beyond five years, when the loan starts to adjust, how much higher might the rate go?
- How much can the rate rise at the first adjustment, after the initial fixed phase has expired? Your “Good Faith Estimate” document should tell you this.
- Will you still be able to afford your monthly mortgage payments if the rate goes up by half a percent, or one percent, etc?
- If you plan to keep the loan beyond the 5-year fixed period, are you comfortable with the idea of an annually adjusting mortgage rate?
If you only plan to keep the loan for five years or less, some of these questions are a moot point. Let’s say you’re going to be in the home for three or four years. In that scenario, you will sell the house and move before the fixed period expires (because you’ll recall the 5/1 ARM loan carries a fixed interest rate for the first five years). It might be a good idea to use a 5-year adjustable mortgage product in this scenario, especially if your primary goal is to minimize your monthly payments.
Refinancing Before the First Adjustment
We have to talk about refinancing, because it’s a common strategy for borrowers who choose the 5/1 ARM (or any short-term adjustable mortgage product, for that matter). If you can refinance your home before the first adjustment takes place, you could avoid the interest-rate uncertainty that occurs after that point.
This is a common strategy used by borrowers who want the best of both worlds. They want the lower rate that comes with a 5-year adjustable loan (see next section), but they don’t want to experience the fluctuation and possible increases that come in the later years. So they take out a 5/1 ARM and refinance at some point before the 5-year mark. You get all of the good with none of the bad.
Will this strategy work for you? It might. But you have to realize there are scenarios where you might not be able to refinance. For example, refinancing might not be possible if…
- you lose your job or otherwise suffer an income loss
- your credit score drops for some reason
- you take on additional debt, resulting in a higher debt-to-income ratio
- you don’t have enough equity in your home when you attempt to refinance
Each of these scenarios could make it hard to qualify for a refi down the road. So you can’t “bank” on it.
On the other hand, if you think there is a high likelihood you’ll be able to refinance before the first adjustment period, then a 5-year ARM loan might be a good strategy for you.
You Could Pay Less Interest in the First Few Years
You’re right about one thing. You will probably save money in the first few years, by choosing the 5/1 ARM over the more popular (and higher priced) 30-year fixed-rate product. Check out Freddie Mac’s Primary Mortgage Market Survey (PMMS) — a weekly survey of average lending rates and other trends across the U.S. — and you’ll see that the 5-year ARM typically has a much lower rate than its 30-year counterpart. The chart below shows this clearly.
The table above is a snapshot of the PMMS during the week of publication (July 1, 2014). It shows the average rates across four mortgage products, and is based on a survey of approximately 125 lenders across the U.S. As you can see, the average interest rate assigned to a 5/1 ARM loan is 116 basis points (1.16%) lower than the average for a 30-year fixed mortgage. So a borrower could potentially save money and reduce monthly payments by using the adjustable product, at least within the first five years.
If you decide to go with the adjustable option, make sure you understand the concept of caps. There are different types of caps applied to these products. They limit the amount the rate can go up from one adjustment to the next, and also for the life of the loan. This is especially important if you plan to stay in the home beyond the initial 5-year fixed period, after which the ARM will adjust annually. Your lender should explain the caps to you, verbally and in writing, when you first apply for the loan.
Disclaimer: This article addresses the question, Is a 5-year ARM a good idea for a first-time buyer? As you can see, there are many considerations and variables that will determine the answer to this question. It is not a “yes” or “no” type of question. We have provided a general overview of the pros and cons associated with different financing options. But there is more to consider when choosing a type of mortgage loan. We encourage you to continue your research beyond this website. This information is intended for a general audience and does not constitute one-on-one financial advice. Every lending scenario is different, because every borrower is different.