Personal Finance

8 min read

July 02, 2021

The 5/1 ARM Loan: What It Is and How it Works

If you’re looking for mortgage financing, you may come across the 5/1 ARM loan. Find out more about it and what to consider.

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If you’re in the market for a new home, you likely will need financing in the form of a mortgage — and you can choose from a fixed-rate mortgage or an adjustable-rate mortgage (ARM).

Fixed-rate mortgages have interest rates that are set in stone during repayment, while adjustable-rate mortgages, sometimes referred to as variable-rate mortgages, can have interest rates that change over the course of repayment.

In this article, we’ll cover what a 5/1 ARM loan is and everything you need to know about it.

What is a 5/1 ARM Loan?

If you’re deciding between types of mortgages, you may be curious about what is a 5/1 ARM loan. A 5/1 ARM loan is typically a 30-year mortgage where the interest rate stays the same for the first 5 years. 

After that, the interest rate reverts back to an adjustable rate. So you’re pretty much signing up for a mortgage with fixed interest rates for the first five years of repayment and, after that, you’ll have an adjustable rate that can fluctuate over time. 

So if you’re wondering what happens at the end of a 5/1 ARM loan: your rate changes every year after the first five years and then you pay off your loan within 30 years (if that’s your repayment term). What Does the '5' Represent in a 5/1 ARM Loan? 

As you can imagine based on the definition of a 5/1 ARM loan, the ‘5’ represents the 5-year fixed interest rate period. The ‘1’ refers to how often your interest rate can change, which is once a year after the 5-year repayment term. 

5/1 ARM Loan vs. Traditional Fixed-Rate Mortgage

A 5/1 ARM loan differs from a traditional fixed-rate mortgage on a couple of fronts. First, the ARM loan is a hybrid loan where you get a taste of both worlds — the first five years you have a fixed interest rate, and the rest of the time you have an adjustable interest rate that can change every year. 

Under a traditional fixed-rate mortgage, your interest rate is fixed — which basically means it stays the same — during the duration of repayment. You can get a fixed-rate mortgage with 15 or 30-year terms. 

The 5/1 ARM loan also typically has a repayment term of 30 years. So the key differences are that with a traditional fixed-rate mortgage, your interest rate remains the same which can help with budgeting and security. You can also choose between a 15 or 30-year repayment term when it comes to a fixed-rate mortgage. 

A shorter repayment term can reduce mortgage interest costs but will result in a higher monthly mortgage payment. A longer repayment term, such as 30 years, means a lower overall mortgage monthly payment. However, you’ll end up paying more in interest as well. 

5/1 ARM Loan: Rate Caps

When you have a 5/1 ARM loan, you get a lower introductory fixed-interest rate for the first 5 years. After that, your interest rate can change. 

But before you get nervous about how much it can increase by, know that there are rate caps in place so lenders can’t hike up the rate indefinitely. For example, your loan may have limits such as not increasing more than 5% above your initial interest rate or no more than 2% with the rate adjustment each year. 

5/1 ARM Loan: Advantages and Disadvantages

If you’re interested in a 5/1 ARM loan, you want to consider the pros and cons. Let’s take a look at the 5/1 ARM advantages and disadvantages. 

Advantages of 5/1 ARM Loans 

  • Starts with a low introductory rate for 5 years 
  • If you sell in a short period of time, this may help save you money 
  • Your rate could go down based on the market trends, saving you money in interest

Disadvantages of 5/1 ARM Loans

  • Can have higher interest rates than other types of adjustable-rate mortgages 
  • Your interest rates may increase every year after the 5 year period 
  • 5/1 ARM rates are determined by the market and economic demands

As you can see, there are some pros and cons to consider. A 5/1 ARM loan may be good if you plan on selling in the short to medium term and this isn’t your “forever” home per se. But be sure to compare costs with other traditional adjustable-rate mortgages. 

Can You Pay Off a 5/1 ARM Early?

If you want to save money on your mortgage, you may wonder if you can pay off a 5/1 ARM loan early. You can, but you may also be hit with some prepayment penalty fees. Typically this is a fee that can be incurred within the first three to five years of the mortgage, according to data from the CFPB. Be sure to check out if your mortgage lender has prepayment penalty fees and what they are. 

Alternatives to the 5/1 ARM Loan

You don’t just have to consider a 5/1 ARM loan, but can look at the alternatives as well. There are other alternative adjustable-rate mortgages, including:

  • 3/1: 3-year fixed interest rate, 1 interest rate change per year
  • 7/1: 7-year fixed interest rate, 1 interest rate change per year
  • 10/1: 10-year fixed interest rate, 1 interest rate change per year

These work similarly to the 5/1 ARM loan in that the first number reflects the number of years your payments will be fixed before switching to an adjustable rate every year for the remainder of the repayment term. You can also consider a traditional fixed-rate mortgage with a 15-year or 30-year term. 

Bottom Line 

If you’re considering a 5/1 ARM loan be sure to check out all of your mortgage options, research 5/1 ARM rates, and find the financing option that will work best for your needs and budget.

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Melanie Lockert
Melanie Lockert
Melanie Lockert is the founder of the blog and author of the book, Dear Debt. Her work has appeared on Business Insider, Time, Huffington Post and more.

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