As you begin thinking about your home loan options, there’s a good chance you’ll be deciding between a fixed rate and an adjustable rate mortgage (ARM). While a fixed rate has been the most popular loan for a while, the ARM is worth considering—and depending on your situation, could be the better option for you.
The gist of the ARM is that it has an initial low, fixed rate period and then the rate adjusts with the current market conditions. Following this initial term, your rate could go up, down, or stay the same.
And that’s just the tip of the iceberg.
While the initial ARM terms can vary (typically 5, 7, or 10 years), we’re going to put the spotlight on the popular 5/1 ARM and emphasize what it is, how it works, and when it may make sense for you.
What is a 5/1 ARM?
The 5/1 ARM is an adjustable rate loan, where the “5” represents the number of years with an initial fixed rate and the “1” indicates that the rate may adjust annually thereafter for the life of the loan. In most cases, you’ll begin with a lower interest rate than you would with a fixed rate loan, which is why many homebuyers like this option. The risk is if interest rates rise after your fixed period, the interest portion of your payment will rise, too.
But don’t let that worry you just yet; a 5/1 ARM could still be in your best interest. More on that in a bit.
How exactly does a 5/1 ARM adjust?
First off, let’s define two terms you’ll need to know:
- Index rate: A benchmark interest rate that reflects general market conditions. The index is determined or maintained by a third party, and will fluctuate.
- Margin rate: Set by your lender when you apply for the adjustable loan. Typically, this will never change.
After the initial fixed rate period of 5 years, the interest rate of the ARM will change based on those margin and index rates. Once your fixed rate period ends, these two rates get added together to become your interest rate. This process will take place yearly after the initial fixed rate period.
When could it be right for you?
As mentioned earlier, depending on your situation, it might be a smart financial move for you to take out a 5/1 ARM. Here are some scenarios in which this could be true:
- You plan to relocate: If it’s likely you’re going to move in the next five years, the potential of a rate increase won’t apply to you since you’ll be moving before the fixed rate period ends.
- You’re anticipating an increase in income: If there’s a good chance you’ll be earning more in the next few years (getting an advanced degree, graduating from a company management program, etc.), then a higher mortgage payment from a potential rate increase may not hurt your wallet too much.
- Refinancing is already on your mind: You might already have a plan to refinance out of the ARM and into a fixed rate loan before the five-year mark. This is the riskiest option, since there’s no guarantee rates will drop when you’re ready to refi.
When choosing the right mortgage loan and terms for you, take the time to weigh your options carefully. Where will you be in five years? Given what you know now, a 5/1 ARM could be in your future.
Learn more about adjustable rate mortgages and other loan options here.
Ditech is not a financial advisor and the ideas outlined above are for informational purposes only. They are not intended as investment or financial advice and should not be construed as such. Consult a financial advisor before making decisions regarding important personal financial matters, and consult a tax advisor regarding the deductibility of interest and tax implications.