Ever wondered what the difference is between a 5/1 ARM and a 5/5 ARM or a 7/1 ARM and a 7/6 ARM and so on? Let me explain it in this article, because the difference contributes to another dilemma that mortgage borrowers should be aware of.
A floating rate mortgage (ARM) is a home loan with an introductory fixed interest rate up front, followed by a rate adjustment after that initial period. The preliminary fixed-rate period is indicated by the first digit, ie a 5-year fixed-rate period for a 5/1 ARM.
The fixed-rate period after the end of the initial introductory period is indicated by the second digit, namely 1-year fixed-rate period for the new rate for a 5/1 ARM.
The main difference between a 5/1 and 5/5 ARM is that the 5/1 ARM is adjusted every year after the five-year lockout period is over. While a 5/5 ARM is adjusted every five years.
Since we know that ARMs make up only a small part of total loans, ARMs with a fixed-rate adjustment period of more than a year are even rarer. But let’s talk about it anyway.
The Most Common Fixed Rate ARM Duration
An ARM generally has a lower mortgage rate than a 30-year fixed-rate mortgage because it is on the shorter end of the yield curve. As a result, more people are likely to take out ARMs as mortgage rates rise.
With a 3/1 ARM, the initial fixed-rate period is three years. In the more common 5/1 ARM, the initial rate fixation period is five years. Personally, I have a 7/1 ARM with an initial fixed rate of seven years.
Then there is the 10/1 ARM with an initial fixed-rate period of ten years. 10/1 ARMs are not as common as they infringe on the 15-year fixed-rate mortgage, which generally has very competitive rates.
Note: There are also 7/6 ARMs and 10/6 ARMs! The 6 stands for six months, not six years. In other words, after the introduction period, the new mortgage interest rate is adjusted every six months.
Choosing the type of ARM based on the yield curve
When I closed my 7/1 ARM in 1H 2020, 7/1 ARMs offered the best combination of the lowest interest rate with the longest initial rate fixation as the yield curve buckled at 5-7 years.
See the yield curve below two months before I locked my 7/1 ARM at 2.125% with no fees. The interest rates for a 7/1 ARM were actually slightly lower than the interest rates for a 5/1 ARM. So I decided to go the 7/1 ARM route for another two years of interest rate stability. After all, I had bought our ‘forever home’.
Before taking out an ARM, take a look at the latest yield curve. Check for dips in the yield curve and decide if that fixed-rate term is something you’re comfortable with. The duration in which there is a dip is where you will get the best value.
5/1 ARM or 5/5 ARM?
The main difference between the 5/1 and 5/5 ARM is that there are more regular interest adjustments on the 5/1 loan, ie every year versus every five years. Therefore, if the mortgage rate and the cost of getting the mortgage are equal, then getting a 5/5 ARM is better than a 5/1 ARM.
However, there is no free lunch when it comes to getting a mortgage. Even free refinancing has costs. The cost is only in the form of a higher mortgage rate that you have to pay.
It is easier for banks to make free refinancing or new free mortgages on larger mortgage balances. There is a wider spread to cover the costs and make a bigger profit.
A 5/5 ARM usually has a slightly higher interest rate than a 5/1 ARM. Therefore, you need to decide and know the following:
How much is the peace of mind of another four years of fixed-rate adjustment period worth? The maximum interest rate that can jump during each adjustment period (initial and subsequent adjustment limit) The Lifetime Mortgage Interest Limit on the 5/1 and 5/5 ARM Where you think the interest will be after the introductory period of the fixed-rate period is over (hard to know! ) The margin and index used. Margin + index = fully indexed interest rate, or adjustable interest rate.
Once you know these factors, you can make a more informed decision.
5/1 ARM vs. 5/5 ARM Example
A Financial Samurai reader noted:
I closed a buy in February with a 5/5 ARM of 1.875%. The margin is 2% and the adjustment limit is 2%. The index is the yield on five-year government bonds. The maximum lifetime rate is 6.875%.
Therefore, the maximum interest rate for years 6-10 would be 3.875%. The other ARM I considered was a 5/1 with a margin of 2.5% and a lifetime cap of 7.875%. The index would have been the one-year treasury. Adjustment limit is also 2%.
I’d like to think I made the better choice with the 5/5 versus the 5/1. Perhaps the difference between the 5-year and 1-year rates would be less than 0.5% if interest rates are reset? What do you think?
(The bank almost made a mistake at the closing table and almost gave me a 5/1 ARM with the 5/5 terms (2% margin on a 5/1 instead of 2.5%). That could have been a bank error in my favor!)
I think the reader made a good choice by knocking out a 5/5 ARM instead of a 5/1 ARM.
First of all, it is better to pay a lower margin. The margin is the profit the bank makes on you. Second, interest rates are currently rising more on the short side than on the long side. The 5/5 ARM’s index deviates from the 5-year Treasury yield, while the 5/1 ARM index is based on the one-year Treasury yield.
Finally, the certainty that you will have to pay a maximum of 3.875% from year 6-10 is reassuring. Even if the 5/5 ARM adjusts by up to 2%, the combined 10-year mortgage rate averages just 2.875%.
No wonder 30-year fixed-rate mortgages are more popular
Based on this example above, it’s easy to see why most mortgages are 30-year fixed-rate mortgages.
Despite higher mortgage rates and a fixed-rate term that is much longer than the average term of an owner-occupied home, 30-year fixed mortgages are easier to understand. And the better you understand something, the more confidence you have in that direction.
But if your goal is to increase your chances of saving the highest possible amount in mortgage interest, you will of course learn everything there is to know about an ARM. As a result, you could end up saving yourself hundreds of thousands of dollars!
When to get a 5/1 ARM or a 5/5 ARM?
In an environment of rising interest rates, a 5/5 ARM is usually more attractive. A 5/5 ARM borrower benefits from delayed adjustments when interest rates rise. The faster interest rates rise after the introduction of the fixed-rate period, the more attractive are ARMs with a longer reset period of one year.
In a declining interest rate environment, a 5/1 ARM is usually more attractive. As rates fall, the 5/1 ARM borrower can profit more easily. The faster rates fall after the introductory rate fix period is over, the more attractive a 3/1 ARM, 5/1 ARM, 7/1 ARM, and 10/1 ARM become.
Keep in mind that it is difficult to predict the future of mortgage rates in 12-24 months, let alone 3-10 years. Therefore, it is generally best to get the lowest possible mortgage interest rate with the lowest cost. A bird in the hand is better than two in the air.
Related: The Biggest Downside to Paying Off Your Mortgage Early
Readers, have you ever taken out a 5/5 ARM or any other type of ARM for more than a one-year reset period? If so, what was your motivation? What was the interest rate differential between a 5/1 ARM and a 5/5 ARM?
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