5/1 Adjustable-Rate Mortgage : How ARMs Work
In this article, we will discuss and cover 5/1 Adjustable-Rate Mortgage and how ARMs work. Ever want to know What is a 5/1 ARM adjustable-rate mortgage but simply haven’t taken the time to read up about it. You probably have heard about these types of mortgages during the financial crisis. But the truth is that an ARM does have a valid place in the marketplace. You just have to understand what it is, and how it works. Yes, it does carry more risk than your standard conventional mortgage. But this risk can be minimized. In this article, we will discuss and cover 5/1 Adjustable-Rate Mortgage For Homebuyers.
Are 5/1 Adjustable-Rate Mortgage Bad For Homebuyers Versus Fixed-Rate Mortgages
Remember that your standard or fixed rate mortgage never changes. You make the same monthly payment for the entirety of the loan. If you are on a fixed income, then this might be the one option for you. There are no surprises.
How An ARM Works
The one difference between an adjustable-rate mortgage and your fixed rate is that the rate can change. There are many different types of ARMs, but we will discuss one of the most popular, which is the 5/1 ARM.
5/1 Adjustable-Rate Mortgage Explained
The 5 stands for the number of years the mortgage rate cannot change. Your payment will be the exact same for 60 months. After 5 years passes then the real fun begins. This is when the rate on your mortgage may change. It can go up or down based on the index rate. But given how our interest rate climate has been so low for so long, it’s a safe bet that it may go up. But there are caps in place that will limit how much the rate can change.
Are 5/1 Adjustable-Rate Mortgage Bad For First-Time Homebuyers
Now after the initial 5 year period is over, your interest rate will reset once a year for the remaining term of the mortgage. Remember, ARM mortgages like the 5/1 may be for a total of 30 years. So in essence, it can change every year for the next 25 years, if you stay in the home, and with the same mortgage. You might compare the reset like you might renew an Austin apartment rental. They are usually around 12 months and apartment rents normally do change once a year.
Are 5/1 Adjustable-Rate Mortgage Bad For Homebuyers Who Plan On Buying A Starter Home
That is pretty much it. There aren’t any specific rules that say you cannot sell or potentially refinance your home. But you will want to read over your mortgage contract. You should also be aware that ARM mortgages start out with a lower interest rate than your fixed. That is the main benefit. So you can afford more homes with an ARM. You could use that extra money to pay off student loans, car loans, or other debt. It’s also a good idea to consider an adjustable-rate mortgage if you expect to be making more money in the next 5 years.
Rate Caps on 5/1 Adjustable-Rate Mortgage
There are a couple of other items that you will want to know. There are rate caps on both how much the rate can reset per year, and over the life of the loan. This is to prevent shock, plus make you aware of how much the rate can change before you agree to the terms of the loan.
Mortgage Index on 5/1 ARM
For those of you still counting, you will want to know what determines whether your rate will go up or down. There are a few mortgage indexes that rates are tied to. These are the CMT, COFI, and Libor indexes.
Advantages of an ARM
- Lower Initial Interest Rate than a Conventional Mortgage
- Lower mortgage payment
- If rates go down, you might have a lower payment
What are the Risks
Simply put, the risks are that your rate may go up, which equates to a larger home payment. If you are on a fixed income, this can potentially put you in a scary position. But there are ways to offset this risk. You can also sell or refinance potentially.
Pros And Cons Of Adjustable Rate Mortgages Versus Fixed Rate Mortgages
Most mortgage loan programs, whether it is FHA, VA, USDA, or conventional mortgage programs offer adjustable-rate mortgages versus fixed-rate mortgages. There are pros and cons of adjustable-rate mortgages versus fixed-rate mortgages. There are advantages and disadvantages of these types of programs depending on the borrower and their needs. Factors like the following play vital factors in choosing adjustable-rate mortgages versus fixed-rate mortgages:
- how long does a homeowner is intending on staying in the home
- how often does the homeowner is intending in refinancing
What Are Fixed-Rate Mortgages
Fixed-rate mortgages are by far the most popular mortgage program. Most mortgage borrowers choose fixed-rate mortgages than 5/1 adjustable-rate mortgage:
- Fixed-rate mortgages are loans that have fixed rates for the term and life of the loan
- For example, a 30 year fixed rate mortgage loan with a starter mortgage rate of 4.25% has the 4.25% mortgage rate for the life of the 30-year term
- Whether interests skyrocket or plummet, it does not affect the interest rate on the note
- They are secured with the 4.25%
- If the interest rates plummet to 2.75%, the homeowner can choose to refinance their current 4.25% rate loan to a new 2.75% mortgage rate mortgage
There are several types of fixed-rate mortgages
- 30 year fixed rate mortgages
- 25 year fixed rate mortgages
- 20 year fixed rate mortgages
- 15 year fixed rate mortgages
- 10 year fixed rate mortgages
Will all fixed-rate mortgages, once the term of the loan is up, the loan has been paid in full. The monthly payments are inversely proportionate to the term of the mortgage loan. The longer the term of the loan, the lower its monthly mortgage payment is.
Amortization Versus Monthly Payments
The shorter the term of the loan, the higher its monthly mortgage payment is. This is because, with the shorter-term home loan, the homeowner is repaying the lender the balance of the loan over a shorter period of time. Shorter-term fixed-rate mortgages normally have lower interest rates. This is because the lender has a shorter-term liability on mortgage rates. Also, with shorter-term home loans, homeowners will save thousands of dollars in interest. This is because they are paying the balance of the loan in a shorter period of time.
Adjustable-Rate Mortgages Versus Fixed Rate Mortgages
Adjustable-rate mortgages are also referred to as an ARM. An adjustable-rate mortgage, ARM, differs from fixed-rate mortgages where the interest rates can change over the term of the loan. One great advantage of adjustable-rate mortgages versus fixed-rate mortgages is that the interest rates of adjustable-rate mortgages are substantially lower. The reason why adjustable rate mortgages interest rates are much lower is that the lender is not obligated to guarantee a certain interest rate for the life of a 30-year term loan. Lenders only have to guarantee a certain interest rate for the fixed-rate period. After the fixed-rate period is over, then the new interest rates adjust based on the index rate. This reduces the risk factor for the lender.
How 5/1 Adjustable-Rate Mortgage Work?
With 5/1 adjustable-rate mortgage interest rates are fixed for a certain period of time. After that period is over, the interest rates adjust every year for the term of the mortgage loan. The new adjustment is based on the index. The payments changes depending on the type of index, plus the margin, which is constant for the term of the loan. For example, say a borrower gets a 5/1 ARM with a starter rate of 3.0%.
Index and the Margin
The margin of 3%. based on the COST MATURITY TREASURIES ( CMT, one-year treasuries ). With this 5/1 adjustable-rate loan program, the interest rate will be 3.0% for the first five years of the loan. After the fifth year, your new mortgage interest rate will adjust. If the CMT, index, is 2.0%, the new rate will be the index plus the margin, 2.0% index plus the 3.0% margin of 5%. Say on year number 7, the INDEX drops to 1.0%. The new interest rate will be the 1.0% index plus the 3.0% margin of 4%. The interest rate will adjust every year until the term of the loan.
Pros And Cons On Fixed Versus ARM
Depending on long-term goals, adjustable-rate mortgages may or may not be the best choice. If planning on purchasing a home and living there for the long term, then a fixed-rate mortgage may be the best option. This is due to security with the fixed-rate mortgage rate. However, first-time home buyers planning in moving in the next five years or so can greatly benefit by choosing an adjustable-rate mortgage loan program versus a fixed-rate mortgage loan. This is due to taking advantage of lower interest rates ARM offers.
Case Scenario on 5/1 Adjustment-Rate Mortgage
If planning on purchasing with an FHA loan here is a case scenario:
- due to bad credit or higher debt to income ratios getting FHA Loans initially
- Planning on refinancing the FHA loan to a conventional loan in the next year or two to avoid the costly FHA mortgage insurance premium
Borrowers may want to choose a 5/1 adjustable-rate mortgage versus a fixed-rate mortgage.