What Is a 5/1 Adjustable-Rate Mortgage (ARM)?

What Is a 5/1 ARM?

The numbers 5 and 1 are important to keep in mind when you're looking into an ARM. The number 5 represents the five-year period when the interest rate is fixed, while the number 1 represents the adjustment of the interest rate once a year following the five-year period.

The majority of mortgages are fixed-rate loans, meaning the interest rate doesn't change unless you refinance. So, if the initial interest rate for a 30-year mortgage is 5.75%, it'll remain at 5.75% for the life of the loan.

Introductory rates for a 5/1 ARM generally are lower than the rates for the popular 30-year, fixed-rate mortgage—often 0.5% to 0.75% lower. For the first five years of a 5/1 ARM, you are guaranteed that lower interest rate and payment, but it could adjust up or down every year after that based on the benchmark rate that's used.

How Does a 5/1 ARM Work?

Figuring how a 5/1 ARM works involves some relatively simple math.

A 5/1 ARM starts with an introductory, or "teaser," interest rate. But after the five-year intro rate expires, the interest rate changes to a "floating" rate based on market conditions, not on your financial circumstances.

How much your payment changes will depend on two main factors: your loan's index and its margin.

Index

The index is an interest rate that reflects current market conditions. Not all lenders use the same index, though, when adjusting an ARM's floating rate.

For instance, some lenders might rely on the U.S. prime rate, which often is the lowest interest rate available. These lenders use the fluctuating U.S. prime rate as a benchmark for setting interest rates on mortgages and other lending products. The prime rate typically is about 3 percentage points above the federal funds rate banks use to lend money to each other.

Other lenders use the Secured Overnight Financing Rate (SOFR), which is a measure of the cost of borrowing cash overnight based on Treasury securities.

Margin

In the case of a 5/1 ARM, a lender adds extra percentage points, known as the margin, to the index after the five-year intro period. The margin, outlined in your initial loan paperwork, never changes, and it differs based on the lender and the type of loan.

Once the index and margin are combined, you'll get your new interest rate.

So, if the index rate is 3% and the margin is 3.5%, the new interest rate for the mortgage would be 6.5%. This could be higher or lower than your initial interest rate—or even the interest rate you paid last year—depending on market conditions when your loan adjusts.

What Are the Requirements for a 5/1 ARM?

The requirements for a 5/1 ARM depend on the type of loan you're getting, such as a conventional mortgage or Federal Housing Administration (FHA) mortgage, along with the lender you use.

For a conventional 5/1 ARM, requirements generally include:

• Minimum credit score of 620
• Down payment of at least 5%
• Typical debt-to-income ratio (DTI) below 45%, although some lenders may allow a ratio up to 50%

For an FHA 5/1 ARM, requirements generally include:

• Minimum credit score of 500
• Down payment of 3.5% with a credit score of at least 580; down payment of 10% with a credit score of 500 to 579
• Typical DTI of 43%, although some lenders may approve an ARM for a borrower with a ratio up to 50%

How to Compare 5/1 ARMs

If you're getting a 5/1 ARM, keep these factors in mind as you hunt for the best deal:

• Introductory rate: This is the interest rate you'll pay during the first five years of a 5/1 ARM.
• Adjustment interval: This is the amount of time between adjustments in an ARM's interest rates. For example, the adjustment interval for a 5/1 ARM is one year.
• Initial adjustment cap: This cap limits how much the interest rate can go up or down after the intro rate ends. A typical initial adjustment cap is 2% or 5% above or below the teaser rate.
• Subsequent adjustment cap: This limits how much the interest rate can go up or down during adjustments following the first adjustment. Often, this cap is 1 or 2 percentage points above or below the previous rate.
• Lifetime adjustment cap: This limits the overall increase or decrease in the rate throughout the life of the loan. The cap often is 5 percentage points above or below the initial rate.

Pros and Cons of 5/1 ARM Loans

Like any mortgage, 5/1 ARM loans come with pros and cons. Here are some of them.

Should You Get a 5/1 ARM?

You may consider getting a 5/1 ARM if:

• You plan to sell the home within a few years, ideally before the rate adjusts.
• You plan to refinance later.
• You're buying when interest rates are higher and you expect them to come down in a few years.

A 5/1 ARM may not be ideal for you if:

• You plan to live in your home for many years.
• You're nervous about the risk of interest rates adjusting.
• You want the predictability of steady payments throughout your loan term.

Alternatives to a 5/1 ARM

If you realize a 5/1 ARM isn't right for you, explore other financing options such as:

• A traditional fixed-rate mortgage: Unlike an ARM, the rate for a fixed-rate mortgage doesn't change unless you refinance the loan.
• An ARM whose intro rate ends after seven or 10 years rather than five: This would give you more time to take advantage of the teaser rate.
• A rent-to-own agreement: This type of agreement lets you rent a home for a certain period with the option to buy it before the lease ends. However, these can be difficult to find.

Frequently Asked Questions

The 411 on 5/1 Adjustable Rate Mortgages

A 5/1 adjustable-rate mortgage can be a great way to buy a home with a lower-than-normal interest rate and lower monthly mortgage payments. However, you may want to avoid a 5/1 ARM if you plan to stay in your home after the introductory interest rate expires or if you wouldn't be able to afford higher mortgage payments if the rate goes up. Be sure to weigh all of your financing options before making one of the biggest buying decisions of your life.