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What is a 5 Year ARM Mortgage?

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A 5/1 ARM is a particular type of adjustable-rate mortgage. It is also known as a 5/25 mortgage. A 5/1 ARM starts with an initial fixed interest rate for five years, then switches to an adjustable rate mortgage. This means the interest rate changes from month to month based on an external index.  An interest rate that changes on a monthly basis can create problems for homeowners. They are faced with variable monthly payments, which makes it difficult to budget in advance. One month the payment is higher and the next month the payment may be lower depending on what interest rates in the economy are doing.

5/1 ARM Definition

The strict definition of a 5/1 ARM is an adjustable-rate mortgage that has a fixed interest rate for the first five years. After this period is up the ARM switches to an interest rate that moves up or down from one month to the next. The degree to which the interest rate moves is determined by referencing an external index that measures the movement of interest rates in the economy. A 5-year fixed loan deals with the variation in interest rates by creating a cap structure. This structure restricts both the speed and the extent of interest rate movements.

Types of 5 year ARM Mortgages

The 5/1 ARM is only one example of a 5 year ARM. A 5 year ARM can be categorized based on its characteristics. The cap structure that keeps interest rates within reasonable bounds may be different from loan to loan. The external index the loan tracks can also be different. Another type of 5-year ARM is the 5/25 arm. This loan's interest rate adjustment period is a full 25 years.

How the 5 year ARM Adjusts

The interest rate on an ARM is adjusted by making reference to the external index. The lender of the mortgage looks at the index and the interest rate cap structure before actually adjusting the interest rate. The cap structure has maximum low points, which are called floors, and maximum high points, which are called ceilings. The interest rate can only be adjusted to the point at which it hits either the floor or the ceiling. Here is a 5 year ARM calculator to calculate changes. It is to the borrower's advantage to get a 5 year ARM that has an interest rate cap structure with a narrow spread between these two points.

Index + Margin = Fully Indexed Rate

Lenders add a few percentage points onto the index rate to get the actual interest rate they apply to the loan. This is known as the margin. The index rate plus the margin rate equals the fully indexed rate. This margin varies from lender to lender, and it is usually constant over the life of the loan. The monthly payment amount changes based on the fully indexed rate, which is rounded to one-eighth of 1% for accuracy. The remaining unpaid principal is then used to calculate the new monthly payment based on the maturity date and the new indexed rate. (1)

Advantages of the 5 year Mortgage

The initial fully indexed rate may be much lower than prevailing mortgage rates. The fully indexed rate is said to be discounted in these situations. This is the primary advantage of a 5 year ARM. The interest rate is fixed for five years, during which borrowers can count on fixed monthly payments. Borrowers often use a 5 year ARM to speculate in real estate. They plan to sell the home before the initial fixed-rate period expires. Another advantage of the 5 year ARM is the cap structure, which may be very favorable to the borrower.

5 year Fixed Rates Vs. 30 year Fixed Rates

Comparing a 5 year ARM to a 30 year fixed-rate mortgage reveals the cost of taking on the extra risk represented by a 5/1 ARM. A borrower's level of confidence about how long he intends to stay in the house directly influences this decision. A low level of confidence means the potential savings from the ARM determine the result. When the rate difference between a 5 year ARM and a 30 year fixed mortgage is more than 1%, the savings accumulated over the 5 year initial period might justify the additional risk. 5 year mortgage rates that differ from 30 year fixed loans by less than 1% usually do not.

Is a 5 year Fixed Right for You?

A 5/1 ARM is perfect for the borrower who is confident he will be able to get out before the initial fixed-rate period expires. The low fixed rate is often competitive compared to 15 year or 30 year fixed-rate loans. This competitive rate makes 5 yr fixed loans attractive to borrowers of a speculative bent.

Qualifying for a 5 year Fixed Rate Mortgage

Currently the borrower will qualify for the greater mortgage rate plus 2% or the fully indexed rate, taking into account the index rate plus the applicable margin. Applying for a 5 year fixed loan can allow the borrower to qualify for a higher loan amount. The higher amount potentially makes a 5 year adjustable rate mortgage riskier.

How Does a 5 Year Mortgage Impact Your Mortgage Qualifying?

Request a free mortgage prequalification using a 5 year mortgage to determine exactly how much you can afford if buying a home or your monthly possible monthly savings of refinancing your mortgage to a 5 year fixed rate mortgage.

References:

(1) https://www.efanniemae.com/sf/formsdocs/documents/notes/pdf/3501.pdf
(2) https://www.stmpartners.com/manual/bro/bulletins/b11/bro11-051.pdf

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