What is a 5/1 ARM Mortgage?

A 5/1 ARM is one of the most popular types of adjustable-rate mortgages in the market today; many people choose this type of mortgage over a 30-year fixed-rate mortgage. Here are the basics of a 5/1 ARM and what it can provide to you as a home buyer.

How a 5/1 ARM Mortgage Works

The term 5/1 ARM means that you will get five years of a fixed interest rate, followed by one-year increments of adjustable rates. This means that for the first five years of the mortgage, you are going to have the same interest rate and the same monthly mortgage payment. After that, each year, your interest rate is going to change, which will also change your monthly mortgage payment. For the next 12 months, you will have the same mortgage payment. Then, at the end of that year, your interest rate is going to change again as well as your payment. This process might go on for the entire length of the loan, or it could stop after a certain number of years.

How the Interest Rate Changes

In order to determine what your new interest rate is, your lender is going to look at a financial index. A financial index is a group of securities designed to give an indication of what the market as a whole is doing. For example, your loan interest rate might be tied to the one-year Treasury rate. Your lender is going to look at the one-year Treasury rate at the end of the year and determine whether it went up or down over the previous 12 months. At that point, your interest rate is going to change at the same rate that the Treasury index changed.

Interest Rate Caps

The thought of your interest rate increasing every single year can be scary. However, most 5/1 ARMs will have an interest rate cap associated with them. This could be an annual cap or a total interest rate cap. For example, your loan might allow the interest rate to go up only by a maximum of two percent each year. This way, even if the index moves up by five percent, your loan interest rate will go up by only two percent. If it has a lifetime cap, the interest rate will be allowed to go up only by a certain amount over the entire life of the loan.

Who Can Benefit

This type of mortgage is not for everyone. However, there are some individuals who can benefit from this type of mortgage. With the initial five-year period, your interest rate is going to be lower than one for a 30-year fixed-rate mortgage. This means that if you plan on living in the house for five or fewer years, you will be able to get a lower mortgage payment during that period. If you plan on making more money in the future, you might also be able to benefit from a 5/1 ARM.

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