5/1 ARM (adjustable-rate mortgage): How it works
Quick insights
- A 5/1 adjustable-rate mortgage starts with a fixed interest rate for the first five years, offering lower initial payments compared to a fixed-rate mortgage. After that initial period, the rate adjusts annually based on market conditions.
- A 5/1 ARM provides short-term savings with lower initial interest rates, making it appealing for first-time homebuyers or those planning to sell or refinance before the adjustment period begins.
- Once the fixed period of a 5/1 ARM ends, rates can increase, leading to higher monthly payments. If market conditions worsen or rates rise significantly, borrowers may face financial strain.
Buying your first home is one of the most important—and most exciting—financial decisions you’ll ever make. However, it can also be one of the most stressful, especially as you’re trying to make your way through a sea of numbers, terms and jargon.
Of these, a 5/1 ARM can be confusing, especially when you consider that there are many other ARM (adjustable-rate mortgage) types to consider, such as 7/1, 10/1 and 5/6.
Feeling lost? We’ll explain how a 5/1 adjustable-rate mortgage works, what it is and when it might be a good option for you.
What is a 5/1 ARM loan?
A 5/1 ARM (adjustable-rate mortgage) is a type of home loan with an interest rate that changes over time. Unlike a fixed-rate mortgage, where your interest rate stays constant for the life of the loan, a 5/1 ARM starts with a fixed interest rate for the first five years (that’s the “5”). After that, the rate adjusts every year (the “1”) based on market conditions.
Why choose an ARM over a fixed-rate mortgage? For many homebuyers, it’s straightforward. A 5/1 ARM often starts with a lower interest rate compared to a fixed-rate loan. This lower initial rate can save you money on monthly payments, at least during the first five years.
Of course, there’s a trade-off. Once the initial fixed-rate period ends, your interest rate (and therefore, your monthly payment) can increase or decrease each year depending on market conditions.
Other ARM options include 3/1, 7/1 or even 10/1 ARMs, where the initial fixed-rate period is three, seven or 10 years, respectively.
How a 5-year ARM loan works
A 5/1 ARM centers around two key phases: the initial fixed-rate period and the adjustment period. For the first five years, your interest rate stays the same—and is typically lower than that of a comparable fixed mortgage. This can help make your payments more affordable, especially in your early homeowner days, when you’re juggling other expenses, like moving costs.
However, after that five-year period, the “adjustable” part kicks in. This isn’t a new interest rate plucked out of thin air, but is instead based on a formula that combines an index (representing current market conditions) and a margin (a fixed percentage set by your lender). Together, these determine your new rate each year, which can go up or down.
Lenders use caps to keep rate increases within limits. The caps you will hear referred to with adjustable rate mortgages are as follows, with their terms outlined specifically for 5/1 ARMs:
- Initial cap: When the fixed period ends, your rate can increase by up to 5 percentage points in year six.
- Periodic cap: After the initial adjustment, your rate can go up or down by no more than 2 percentage points annually.
- Lifetime cap: Over the entire loan term, your rate can never increase by more than 5 percentage points beyond the starting interest rate.
What does this look like in practice? Let’s say you lock in a 6% interest rate on your 5/1 ARM. After five years, if market rates rise, your rate could jump to 11% (a 5% increase due to the initial cap). Over the loan’s life, though, your interest rate would never exceed 5% more than the starting rate.
How long does a 5/1 ARM last?
Most 5/1 ARMs have a 30-year term. The first five years are fixed, and the remaining 25 years are adjustable. Once you hit the adjustment period, your interest rate and payments will change annually.
ARMs can save you money if you plan to sell or refinance before the adjustment period begins. However, if you’re staying in your home long-term, the unpredictability of rising rates might make a fixed-rate mortgage a safer bet. That said, you can always stay in your home longer than five years (or however long your mortgage is for). There are no rules about keeping your home past the initial period and the loan functions similar to a fixed-rate mortgage in that way.
What is the minimum down payment for a 5/1 ARM?
Qualifying for a 5/1 ARM loan is similar to qualifying for a fixed-rate mortgage. Typically, lenders look for a down payment of at least 5% and a credit score of at least 620. You’ll also need a debt-to-income (DTI) ratio below 45% in most cases, though there are some lenders that allow up to 50% based on other factors.
Your lender may also take your overall income stability into account to make sure you can handle possible rate adjustments in the future. As a borrower, shopping around is important because different lenders may offer more competitive rates or terms.
What to look for when shopping for a 5/1 adjustable-rate mortgage
Before deciding on a 5/1 ARM, there are a few things to be aware of:
Understand the loan caps
First, check the “caps” on the loan. Caps limit how much the interest rate can adjust, which ultimately means your payments won’t increase infinitely. There are typically three caps:
- Initial cap: This limits how much the rate can increase after the fixed period ends.
- Subsequent adjustment cap: This sets a limit on how much the rate can change annually.
- Lifetime adjustment cap: This limit caps how much the rate can increase overall throughout the life of the loan.
Caps (and adjustments, as described below) can vary significantly depending on the lender, institution and even the year the loan is offered. For instance, some lenders may offer lower initial caps to make their loans more appealing, whereas others might focus on more favorable lifetime caps to provide long-term peace of mind.
The economic climate can also influence the type and magnitude of caps lenders are willing to offer. A loan during a low-interest rate period may have different caps than one provided during periods of high-rate volatility.
Consider the adjustment intervals
Make sure you thoroughly understand the adjustment intervals, which determine when and how your interest rate will change. Coupled with the fixed period and the overall loan structure, these intervals can significantly affect how manageable the mortgage feels short- and long-term.
Explore loan variations
Beyond traditional 5/1 ARMs, there are options that may better suit your financial goals and situation:
- Convertible ARMs: Convertible ARMs give you the option to switch from an adjustable rate to a fixed rate after a certain period. This can be advantageous if you anticipate wanting more stability in the future or if interest rates start to rise, but conversion does typically come with additional costs.
- Interest-only ARMs: Interest-only ARMs offer lower monthly payments during an initial interest-only period, where you’re not required to pay toward the loan principal. This can be a good choice for borrowers who want to minimize payments or plan to sell or refinance before the loan adjusts. Keep in mind, once the interest-only period ends, payments often increase substantially as you start paying off the principal.
Advantages of a 5/1 ARM
There’s a reason why first-time homebuyers may feel drawn to the 5/1 ARM. For starters, it generally comes with a lower initial interest rate compared to a traditional fixed-rate mortgage. That means your monthly payments can be more budget-friendly at the start, making homeownership feel a little less overwhelming.
Over time, this lower initial rate could mean paying less interest, particularly if you plan to sell your home or refinance before the adjustable period kicks in. A 5/1 ARM could be a good fit if you know your current home is merely a pit stop on your path toward something bigger (or in a different zip code).
For those who only need the loan short-term, like if you’re buying a starter home or know your income will grow significantly over the next few years, the 5/1 ARM can also provide greater financial flexibility.
Disadvantages of a 5/1 ARM
Of course, there are some downsides to 5/1 ARMs, too. First, once that initial five-year period ends, the chance of your interest rate increasing is very real. This could lead to higher monthly payments, even ones significantly beyond what you’re paying during the fixed period.
The difference in the starting rate compared to a fixed-rate mortgage isn’t always massive, so the benefits might feel underwhelming in some market environments. Plus, if interest rates increase substantially, you could end up paying more interest over the life of the loan compared to sticking with a fixed-rate option.
To give you an idea of whether an ARM will be a good fit for you, have an open and honest conversation with your lender. You can also do the following:
- Estimate potential long-term costs: Calculate how much you could end up paying over the life of the loan by factoring in rate caps and expected changes in interest rates. Many online calculators can provide an estimate.
- Compare starting rates and projected increases: Compare the initial rate savings against the potential future costs of rising rates. Ask your lender for assistance in forecasting how rate adjustments might impact your payments.
- Monitor interest rate trends: Keeping an eye on current and projected rate movements can help you decide if an ARM aligns with your financial goals.
Ultimately, if the idea of fluctuating, somewhat unstable payments makes you nervous, an ARM may not be the right choice. Unless you’re in a position where you can comfortably cover the maximum potential payment without putting a massive dent in your budget, other mortgage options may be worth considering.
Is it a good idea to have a 5/1 ARM?
A 5/1 ARM is ideal for some buyers—but not everyone. It all boils down to your specific situation and financial comfort zone.
If you're planning to live in your home for less than five years or are confident you'll be refinancing before the adjustment period, this mortgage could save you money on interest while keeping your short-term payments lower.
On the other hand, you’ll need to be honest with yourself about the risks. If the idea of unpredictable payments keeps you up at night, a fixed-rate mortgage could be the better choice for peace of mind.
It’s also important to factor in your income prospects. Do you expect your income will grow significantly in the near future? Can you put down more than the minimum upfront? And most importantly, could you handle the maximum adjusted payment if rates peak?
If the answer to any of these is “no,” an adjustable-rate mortgage might not be worth the gamble.
In summary
A 5/1 ARM has its fair share of perks, particularly for first-time homebuyers looking to get their foot in the door of a starter home without feeling burdened by higher monthly payments. However, you should only proceed if you’re comfortable managing the risks. Do your homework, shop wisely for a lender and make sure you’re asking detailed questions during the process.
Not sure where to start? Speak to a trusted lender or financial advisor who can help you decide if a 5/1 ARM aligns with your long-term goals and financial situation. After all, buying your first home should be a rewarding experience, not a stressful one.
