UPDATED: Apr 28, 2023
With interest rates rising, many borrowers are looking for ways to lower their monthly mortgage payment. If you don’t plan to stay in your home long, one option you can consider is a 5/1 ARM.
With a 5/1 ARM, you’ll receive a low interest rate for the first 5 years you hold the mortgage, potentially saving you thousands of dollars in interest. But it’s important to understand the potential risks before choosing this type of loan option.
A 5/1 ARM is a hybrid fixed-rate/adjustable rate mortgage. That means that, for the first 5 years, the borrower enjoys a guaranteed introductory teaser rate. Thereafter, they agree to annual adjustments and shoulder part of the risk of interest rate hikes. ARMs are one of the many types of home loans available to borrowers who are interested in buying a house.
An adjustable-rate mortgage (ARM) comes with a low introductory interest rate for a set period of time. Once the introductory period expires, your rate will adjust annually based on market conditions. There are a variety of ARMs available, each with different introductory periods and rate caps available.
In comparison, fixed-rate mortgages have a set interest rate for the life of the loan. This rate will almost always be higher than the introductory rate you’ll receive with an ARM, but you never have to worry about your mortgage payments changing.
For the first 5 years of your loan, you’ll receive a low fixed-interest rate. Once this initial fixed-rate period is up, your interest rate will adjust annually. During this adjustment period, your lender recalculates your rate so it could be higher or lower than the initial rate.
However, your interest can’t go up indefinitely – a rate cap limits how much the interest rate can rise. The rate cap will vary depending on the loan you qualify for, but most rate caps are 5%.
Your ARM rate can vary depending on a number of different factors. For instance, the length of the introductory period, how frequently the loan adjusts, and any applicable rate caps will all have an impact on the total cost of the loan.
Perhaps you’ve considered applying for an ARM, but you’re worried these loans are too risky. ARMs can become more expensive after the initial period, that’s true. But in certain scenarios, it may make sense to apply for one.
ARMs are designed so that borrowers share the risk of higher future interest rate hikes. In comparison, lenders alone take on this risk with fixed-rate mortgages, which is why ARMs come with such a low introductory rate.
This initial low interest rate is becoming an increasingly attractive option for borrowers as interest rates continue to rise. However, borrowers should always understand that their interest rates may rise, how often they can rise, and how much they can rise.
One option is to take advantage of the low introductory rate an ARM offers, and then refinance your mortgage before the introductory period expires.
ARMs took a share of the blame for the subprime mortgage crisis and the 2008 Great Recession. For many people, this stigma – along with extremely low interest rates on fixed rate mortgages over the last decade – made ARMs a less popular option.
But mortgages have changed since 2008 thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). These laws required changes in regulations affecting qualified mortgages – ARMs included – that Fannie Mae and Freddie Mac will purchase after origination. The truth is that ARMs are a top choice for financially savvy homeowners.
ARMs are an attractive option to anyone looking to save as much as possible on their mortgage interest payments. This is especially true if you plan on moving in the next 4 – 7 years, or are comfortable refinancing before the end of the introductory period.
However, ARMs do carry an inherent risk – your rate could rise and your payment could become higher. However, the important factor is how much you’ll save in interest during the initial low-rate period, and how much it’ll cost you to refinance if rates do rise. If the numbers work out in your favor, you definitely might want to consider an ARM.
ARMs can be a great option for borrowers who want to take advantage of a low introductory rate and save thousands in interest. This is especially true for more expensive homes, which provide higher interest savings with ARMs. But some home buyers might not want to worry about a refinance after several years. They would rather pay a “premium” for the certainty of a fixed rate. The premium is the amount of interest saved during the initial lower-rate period of an ARM vs. a fixed-rate mortgage.
One of the advantages of a fixed-rate mortgage is the certainty that comes with it. If you’re looking for a consistent monthly payment and want to save on your overall interest rate, you may want to consider a 15-year mortgage.
Qualified ARMs offer consumer protections to prevent the types of issues that arose leading up to 2008 and are a great choice for some home buyers. If you’re ready to take the first steps toward homeownership, you can get started by applying online today to find out if a 5/1 ARM loan term is right for you.
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