5/1 ARM Rates are a Bargain, But Not Without Risk

By Alvaro Moreira
11 min read

5/1 ARM Rates are a Bargain, But Not Without Risk

5/1 Adjustable-Rate Mortgage (ARM) Rates are Cheap, But Not Without Risk

Adjustable-rate mortgage rates are generally always smaller compared to the rates for a fixed-rate mortgage (FRM).

From 2005, 5/1 ARM rates have averagely been around 0.6% lower than 30-year FRM rates. To clarify, a 0.6% decreased rate could see you save nearly $1,000 annually on a loan of $250,000. However, you should bear in mind that ARMs are riskier compared to fixed-rate loans. After a short-term fixed-rate duration, the rate of your ARM could potentially increase each year (or drop, if you’re fortunate).

So, how do you determine whether that prospective $1,000 and over savings gap is worth it?

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5/1 ARM Rates Vs. Fixed Mortgage Rates

ARM’s interest rates are usually reduced compared to their fixed-rate corresponding mortgage loans. Going by Freddie Mac’s data, it’s evident that 5/1 ARM rates have remained under rates for 30-year- fixed-rate mortgages for a while now.  However, you should note that ARM rates aren’t the smallest all the time.

It’s all contingent on the timing – and how ready you are taking on extra risk to yield more savings.

5/1 arm rates
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How the 5/1 ARM Functions

ARMs are quintessentially adjustable-rate mortgages.  This means that they differ from fixed-rate mortgages, which are undoubtedly the most sought-after house loans in the U.S.

The distinction is in their names. An FRM will retain its rate throughout the entirety of the loan term. However, an ARM mortgage rate has the tendency of fluctuating depending on the market.

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The 5/1 ARM can be described as a ‘hybrid’’ ARM. As a matter of fact, the majority of ARMs are in principle ‘hybrids’. This implies that they are part-adjustable and part-fixed.

Hybrid loans will be set at a fixed rate for a predetermined period, and then will be flexible for the entirety of the loan term. A 5/1 typically has a 5-year fixed rate… after the 5-year period has lapsed, the lender can modify your rate annually.

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A 5/1 ARM means that you’ve got a fixed rate for the initial 5 year period, a 7/1 for the initial 7 year period, and a 10/1 for the initial ten year period. There are also other ones like a 1/1 ARM. However, the above mentioned — 5, 7, and 10 — are the most sought after.

What’s the meaning of the ‘1’ in ‘5/1’? This implies that following the 5-year fixed duration, the lender can modify the payable rate each year.

The payable interest rate may fluctuate every year during the entirety of your loan spell, and will be contingent on how the markets behave. The same case applies for 10/1 and 7/1 ARM rates. 

How 5/1 ARM Rates Are Determined

Mortgage lenders compute 5/1 rates – as well as other ARMs – using these factors as the basis:

  • The financial rate indicator to which your ARM rate will be linked – These rates constantly fluctuate and you can find the financial indexes published every day in The Wall Street Journal 
  • Your “margin” – This is the figure that will be included in your index rate to indicate the additional risk your specific loan has. Every ARM carries a margin. However, you can expect yours to be higher if you have a low credit score, if you’re borrowing a bigger share of your house price, or if you’ve got numerous outstanding debts. 

When the lender has determined your rate index, it can get modified. Your margin should stay unchanged throughout the entirety of your loan. After closing, you and your mortgage loan are at the mercy of financial markets, which are determined by the rates set by the Federal Reserve for instance. To put everything into perspective, when you’ve acquired your ARM, your rate will be separated from other mortgage charges.

Following the first fixed-rate duration, it will entirely be governed by normal interest rates as mirrored in your specific financial rate indicator.

Caps Mitigate Prospective ARM Risk

Almost all ARMs encompass caveats on the sum their rates can increase. Make sure to review your loan estimate to confirm that you do – and it offers the safeguards you require.

If you’re searching for an ARM, ask every lender you encounter for its guidelines on limits.

Caps generally come in two forms:

  • A yearly cap – This protects you from feeling the pinch if the interest rates suddenly surge
  • An overall cap — This constricts the amount your rate can increase in general over the entirety of your loan

Caveats provide essential safeguards. However, you’re still susceptible to the risk of rates increasing. And you should always keep that in mind.

Why 5/1 Arm Rates are So Low

From the chart illustrated above, you can clearly see that ARM rates are averagely reduced compared to FRMs, even for an identical borrower looking to get an identical loan. And it’s actually expected.

Let’s say that during the coming 5 years, rates all of a sudden surge to 18% for a 30-year FRM (which was actually the index in October 1981). With a FRM loan, the lender is the one that bears all the risk of lending to you at present day uber-low rates. However, with a 5/1 ARM, the risk burden will be shared with you – subject to rate caveats. And reduced risk usually translates to reduced interest rates.

Why are 15-Year Mortgage Rates Smaller Compared to ARMs?

Using the chart illustrated above, ARM rates are often significantly smaller compared to 30-year fixed mortgage rates. 

However, you may have noticed that rates of 15-year FRM and 5/1 ARM rates are nearer to each other. As a matter of fact, at the beginning of 2019, 15-year FRMs have constantly been smaller compared to 5/1 ARM rates.

Why? Well, the short answer is that a 15-year FRM is a short loan term.

When you go for a 5/1 ARM, you take on some of the risk burden of the lender by accepting to assume an increased rate should the financial markets alter in future. This is the reason why ARM rates are reduced. When you go with a 15-year FRM, you’re essentially bearing more of the lender’s risk as you’ll have committed to paying off the loan in half the duration. However, when you have a 15-year FRM, you’re essentially bearing even more of the risk as you’ll have committed to paying off the loan in half the duration. (Note that a 5/1 ARM is still categorized as a 30-year loan.)

Still, a 15-year loan, such as the 5/1 ARM, has significant disadvantages for borrowers. So, what’s the catch? Given how you’ll be settling a 15-year FRM in half the loan period, the payments will be considerably bigger. Therefore, although a 15-year loan may seem appealing for its cut-price rates, buyers will have to compare their interest rate savings to their capability of making bigger monthly payments.

Rates for 5/1 ARMs vs. 7/1 or 10/1 ARMs

From the lender’s perspective, a 5/1 ARM is more enticing compared to a 10/1 or 7/1 ARM. This is because you’re bearing some of the risk for an extended duration.

Let’s say you prefer a 30-year mortgage, a 5/1 ARM suggests that you’ll share that risk for the next 25 years. However, a 10/1 will suggest that you’ll be doing so for the next 20 years. 

Lenders typically try to encourage you to shoulder more risk. They do so by providing reduced rates for a provisional fixed-rate duration. This subsequently means that 1/1 ARMs are the most inexpensive of all.

Advantages and Disadvantages of Adjustable-Rate Mortgages

To comprehend the downside of a 5/1 ARM, you need to know why many individuals prefer fixed-rate mortgages. 

There’s something very reassuring about going with a 30-year fixed rate mortgage loan. Having peace of mind that your monthly payments – from the initial through to the last – will not change really gives some sense of security.

It’s a one-way path. If the rates increase, you’ll remain untouched by the changes. However, if they drop, you can opt to refinance into another, reduced rate. 

In that case, you’re giving up a lot. Therefore, in what scenarios can it be prudent to acquire an ARM? 

When you think you’ll be relocating in a couple of years – If you’re looking to remain in the home for the entirety of your loan term, then it’s obvious what you should do. Many persons relocate roughly after every 7 to 10 years, hence 10/1 and 7/1 ARMs should be in demand than they are

If you’re planning to complete paying the loan in the fixed-rate duration – If you are certain that you will amass the necessary funds to pay the loan within x years, then there’s no need of you paying more money to get the security of a 30-year mortgage

When you think the financial rates will drop from here henceforth – It will be in your interests to go for an adjustable-rate loan if you’ve assessed the financial climate and established that it will drop. However, given how economists are often wrong when it comes to predicting mortgage rates, we advise that you take caution before making any call

If there’s a significant margin between FRM and ARM rates – To put it differently, if the rate you’re currently receiving on an ARM is considerably lower compared to what you could receive on an FRM that it’s too good to pass up

When you want to acquire a jumbo loan – Jumbo loans (when what you’re borrowing is more compared to the current loan caps) have increased FRM rates compared to ARM ones. Choosing the latter may be the most economical way forward

As you can see, there are several scenarios whereby going with an ARM can be a prudent idea.

Arms Still Come With Their Fair Share of Risk 

You may be under the impression that the risk associated with ARMs is small. And going by the past 10 years or so, you’re not wrong. For years now, everybody anticipated mortgage rates to go back to their pre-Great Recession period. And so far so well, they haven’t. Individuals with ARMs have performed better than everybody. 

However, as much as that’s a comfort, it’s also a warning sign. Following the financial disaster of 2007-08, the global financial climate has been anything but. At the same time, COVID-19 hasn’t really helped stabilize matters.

And that suggests that there are no guarantees. A small number of people now expect rates to increase in the foreseeable future. However, few are anticipating any significant financial changes in history. These things spring up on you without warning.  

You can do a personal risk analysis that in most scenarios could make going with an ARM the best choice. However, don’t presume that there’s no risk involved.

5/1 ARM FAQ

Is a 5/1 ARM a good idea?
A 5/1 ARM can prove to be a prudent decision. For example, if you think that you’ll relocate or decide to offload the house within 5 years (or 7 years, if you select a 7/1 ARM), the burden will be restricted to those plans going sideways. A 5/1 ARM may be a good decision if you’re looking to raise the buying budget of your house with a reduced rate.

And it can also be a prudent idea if you meet any of the circumstances of obtaining an ARM we listed above.

What is a 5/1 ARM rate? 
This is basically the payable rate amount on 5/1 ARM. For the initial 5 years, the rate won’t change. However, after that duration has lapsed, it can be flexible with other interest rates depending on the financial environment. 

Nevertheless, many ARMs come with caveats that restrict the sum that your rate can increase, both annually and overall. Ensure that yours has a cap and that those caveats offer the safeguard you require.

Can you pay off a 5/1 ARM early? 
Not all the time. However, that is contingent on the lender. Thera re lenders who set prepayment charges that go into the thousands. Those penalties are applicable within the initial 3 or 5 years of the loan’s life term.

There are loans that come with hard prepayment levies, which means you’ll shell out more on penalties or fees if you settle the loan during the penalty duration. Others will have lenient prepayment penalties, which means you’ll pay extra penalties or charges if you opt to refinance. 

Can you refinance an ARM loan?
Yes you can. The majority of mortgage plans make it fairly simple for you to shift from an ARM to an FRM. You may even have met the qualifications for a streamline refinance that come with minimal hassle and costs.

However, you may be charged if your refinance is done hastily and your lender sets prepayment levies (view the previous question).

How soon can you refinance an ARM?
Whether or not you can refinance your SRM solely depends on the policies of your lender. Some lenders don’t set prepayment levies. Some will charge you to refinance your ARM within 3 years, while others will penalize you within 5 years.

Make sure that you review your loan quotation and arrangement and talk it out with your lender before committing to a particular lender.

Are ARM loans bad?
If you talk to individuals with ARMs over the past 12 years, chances are that they will have positive things to say. They may say it’s the best decision as the rates have been constantly dropping. And what began as an awesome deal has just gotten better as the years have lapsed. 

However, bear in mind that ARM rates may rise one day. And when that happens, it may present a significant risk to those persons whose rates are floating outside their original fixed-rate duration.

How to get a small 5/1 ARM rate?

Always do your research when searching for a mortgage. Every lender has different ARM rates much like other loans do. Check whether the prepayment policies of your lender suit you. So long as you cautiously approach ARMs, you can mitigate your risk exposure. For others, obtaining a 5/1 ARM may be best.