Housing costs have skyrocketed as of late, with median home prices near historic highs and mortgage rates hitting levels not seen in 23 years.
So, it’s little wonder that the overall affordability crunch in the real estate market has cash-strapped homebuyers exploring potentially riskier financing options with the promise of a lower mortgage rate.
Enter the 5/1 adjustable-rate mortgage, or ARM. This type of loan—the most popular ARM out there—has what’s called an introductory “teaser” rate that’s lower than what you’ll get with a fixed-rate mortgage.
Locking in a 5/1 ARM for your mortgage might be suitable for specific circ*mstances or a terrifying financial roller-coaster ride you can’t wait to exit. If you’re considering getting an ARM, here’s what you need to know first.
What does 5/1 mean?
ARMs are denoted by how long your interest rate will remain fixed and how often your rate will adjust after the fixed period expires.
So, with a 5/1 ARM, you get to hang onto that lower introductory interest rate (and monthly payments) for five years. When the five years are up, the interest rate and your monthly payments adjust either up or down, once per year for the life of the mortgage.
When exactly does the rate adjust?
Here’s the big catch of the 5/1 ARM: When the initial rate expires, the adjustment period begins. Then you’re at the mercy of the prevailing market rates, which could be much higher—or sometimes lower.
“The new rate usually starts on the anniversary of the loan each year,” says Alex Shekhtman, CEO and founder of LBC Mortgage in Los Angeles.
When mortgage rates go up, so do your monthly payments. And if rates go down, your payments decrease. Just how much your rate rises or falls depends on your lender and other economic factors.
“The new rate is determined annually based on specific financial indices, such as the U.S. prime rate or London interbank offered rate, plus a margin set by the lender,” says Shekhtman. “This helps match the rate with what’s happening in the market.”
How much can the interest rates rise?
Just how far north your mortgage rate can go depends on the lender you choose and the details of the interest cap agreement of your ARM loan. Caps protect you from steep year-to-year rate hikes by specifying how much your interest rate can go up or down for each adjustment period and the life of your loan.
A typical 5/1 ARM has three caps:
- The initial adjustment cap is the maximum amount the rate can rise at the first adjustment.
- The periodic rate cap is the maximum amount the rate can change each time it resets.
- The lifetime cap is the maximum amount by which the rate can change over the life of the loan.
Pay attention to the cap details
With the potential for many rate fluctuations, ARMs can be more complicated and confusing than a standard 30-year fixed-rate mortgage. So, when comparing loan options, pay close attention to the caps.
For instance, you might see lenders advertise a 2/2/5 or 1/1/5.
“Our caps are 1/1/5,” says Christy Bunce, president of New American Funding. “What that means is the interest rate can only increase by 1% each year after the five-year fixed period is up.”
A 2/2/5 denotes that a rate can’t increase or decrease by more than 2% for the first adjustment after the fixed period ends.
Still, doing the math can be complicated, so ask your lender to calculate the highest possible payment you may face paying to have a clear picture of what worst-case scenario to expect. You can also look for this information in the Truth in Lending disclosure, which lenders must provide to borrowers within three days after they apply for a loan.
Qualifying for a 5/1 ARM
Lenders will scrutinize your whole financial profile with any mortgage loan, including credit history, income, assets, and debt-to-income ratio.
With a 5/1 ARM, lenders also have to consider if you’ll be able to pay the highest possible monthly payment after the initial low-interest period is up.
“For example, if your initial rate is 7%, and the initial adjustment cap is 2%, then you will be qualified considering a payment based on a 9% rate,” says Scott Beal, co-founder of Loan Garden, in Lakewood, CO.
When the 5/1 is a good fit
The 5/1 ARM might be a perfect loan option for specific scenarios, especially if you’re considering selling your home in the first five years of ownership, says Shekhtman.
If you don’t plan to move within five years, you can also refinance your 5/1 ARM to a fixed-rate mortgage once the teaser period is over.
“Taking a 5/1 ARM with the intention of refinancing in the future can be a good strategy in an environment where rates are high, but one believes they will be lower in the near future,” says Beal. “Refinancing is easy and generally inexpensive or even free.”
ARMs are not a great idea for buyers on unsteady financial grounds. You could lose your home if you lose your job or run into other financial woes and can’t refinance.
The bottom line
Another factor to consider if you are pondering a 5/1 ARM is the housing market’s current state.
According to Beal, we’re in an inverted yield curve, which occurs when shorter-term interest rates exceed long-term interest rates for U.S. Treasury securities, creating a belief that the short term is riskier than the long term.
“Lenders are assuming that anyone who gets into an ARM now will refinance within the next couple of years,” says Beal. “Since borrowers won’t hold the loan for very long, the investment doesn’t make sense for the lender unless they charge higher rates and fees.”
And if you’re not getting lower interest rates commonly associated with an ARM, it won’t save you money on monthly payments.
