Buying a home is one of the most – if not the most – expensive purchases any person will make. It requires a huge amount of money which, in most folks’ cases, are not easily accessible. So they turn to lenders and hope to get great deals on mortgage loans. One of those loans is the 5/1 ARM loan.
5/1 ARM Loan: What is it Exactly?
Those who are not as well-versed in the world of real estate financing might be scratching their heads and wondering, “What is a 5/1 ARM mortgage?”
A 5/1 ARM loan, or an adjustable-rate mortgage loan, is a combination of the typical 30-year fixed loan and an adjustable-rate mortgage. What it does is offer home buyers and investors a short-term period where the interest rate is fixed and can only be adjusted after the predetermined period. In this case, the period where the interest rates are fixed is five years. After the loan’s first five years, the interest rates are adjusted accordingly to the different indices attached to it.
Most lenders use the following indices to figure out the loan’s adjusted rates:
- Secured Overnight Financing Rate or SOFR.
- Cost of Funds Index or COFI.
- Constant Maturity Treasuries or CMT.
Simply put, it offers house buyers a loan where the interest rate is fixed for the first five years and is then adjusted only once for each succeeding year until it reaches its full term. Most 5/1 ARM loans are on a 30-year term but there are several instances where terms can be shorter.
How Does It Work?
To better understand 5/1 ARM loans, one needs to understand how a fixed-rate mortgage and an adjustable-rate mortgage loan work.
Fixed-rate mortgages are housing loans that are paid in installment over a certain number of years. The loan usually covers a period of 30 years and has a fixed interest rate during the entire term. This type of loan is quite popular among homebuyers, especially for those who aren’t really in it for profit. It gives them a certain fixed amount that makes their monthly budgets easier to manage.
Although the interest rates in fixed-rate mortgages may be a tad higher than other types of loans, the stability it offers is enough for a lot of folks to take it.
On the other hand, an adjustable-rate mortgage is more unstable therefore a lot riskier. The interest rates can change depending on the different indices they are attached to. And indices are determined by a lot of economic factors. So if the economy is doing really well, a certain index may either hit a plateau or go lower than its status in the previous year. When it does that, the interest rate on the mortgage will follow suit. However, if the economy is in bad shape and recession is looming, index rates may spike which causes a huge unexpected increase in the mortgage’s interest rate.
Now a 5/1 ARM loan combines both ideas for the benefit – supposedly – of home buyers and investors. Once a buyer takes up this type of loan, the interest rate on it – usually lower than the conventional rates – will be locked in for the first five years of the loan. If the interest rate at the onset of the loan is at 2.5%, it will stay that way until the end of the fifth year.
When the first five years are up, a new computation will be drawn against the loan to determine the new interest rate for that particular year. Interest rates are now subject to changes moving forward. However, they can only be changed only once per year. Any further increase or decrease in interest rates will take place in the succeeding year.
Let’s say a buyer or a real estate investor decides to purchase a property and applies for a 30-year loan for $250,000. In a fixed-rate mortgage with 4% interest, the buyer will be paying a fixed amount of $1,193.54 for the entire duration of the term, sans insurance and taxes.
With a 5/1 ARM loan where the initial interest rate is lower for the first five years, the homeowner will only have to pay $1.122.61 for the first 60 months of the loan. That’s already a savings of almost $71 compared to a fixed-rate loan. However, it is important to keep in mind that the rates will change in the sixth year, and every year thereafter. Depending on the cap provided by the loan, the monthly mortgage payments could be around $1350 in the sixth year.
For instance, in the seventh year, the interest rate increases again at the maximum amount allowed by the cap, a homeowner could be looking at a monthly mortgage of $1650. If things continue to go up to 5% in the eighth year, the new payment for the next 12 months could be almost $1800.
For this reason, those who are looking to buy a property, whether for personal use or real estate investing, should have a pretty good grasp of the relationship between principal and interest. This is why careful thought and planning should be taken by buyers and investors, especially if they’re after a good return on investment.
The Pros: Why Should Investors Consider Getting It?
Basically, people who are into real estate investing are in it for profit. Whether they plan to flip properties or rent them out, the goal is to make the most profitable decision. Real estate investment is a very lucrative business venture when done well. With the right tools and strategies, investors can make really good money off it. They just need to know the right information and data to make the wisest decisions.
A 5/1 ARM loan is one of those things that can prove helpful in the real estate market. Here are some of the advantages it offers real estate investors:
It is Ideal for Short-term Ownership
Homeowners and investors who have no intentions of holding onto the property beyond five years will greatly benefit from a 5/1 ARM loan’s low-interest rates.
It Has a Lower Initial Interest Rate
Because of the way it is designed with interest rates bound to change after the fifth year, this type of loan offers buyers a lower fixed interest rate for the first five years. The money saved can be used to furnish the house, invest in other ventures, or build a savings account.
It Allows Investors to Pay Off More of the Principal Amount Early
While some loans have prepayment penalties in place, most ARM loans don’t, which makes it easier for buyers to put back in the principal amount. This way, even when the interest rates go up after five years, the interest they will be paying will be computed from a lower base number.
The Cons: Why Shouldn’t They Get It?
Now everyone knows that all things have their own sets of advantages and disadvantages. As mentioned earlier, a 5/1 ARM loan is not for everyone. Here are some reasons why it won’t work for certain people:
It Will Not Work Well with Long-term Ownerships
For those who intend to hold on to a property for more than five years, an ARM loan might not be suitable for them. While the initial fixed interest rate is lower, the succeeding years’ rates could spike significantly depending on the real estate market and other economic factors. This means that a property owner will most likely pay more interest over time.
Refinancing is Possible But Very Expensive
Refinancing a house under a 5/1 ARM loan is technically possible when higher interest rates start to kick in. However, it will come at a very high cost – closing cost, that is. Closing costs can go up to as high as 6% of the amount you owe.
The Rate Differences and their Unpredictable Nature Aren’t Worth It
While buyers tend to enjoy low fixed interest rates in the first few years of homeownership, things can get pretty nasty when they become adjustable in the sixth year. Depending on how the different indices do, things can either work for or against a property owner. While a plateau or decrease still happens occasionally, the general direction in which interest rates go is upwards.
In the event that the mortgage spikes and the borrower can’t make any payments on time, his or her credit score will take a beating. If the borrower is unable to make any payment at all, he or she could lose the property.
When Should an Investor Consider a 5/1 ARM Loan?
Given the different advantages and disadvantages of this particular loan type, the question now is when should investors consider getting one? When does it make sense to get one over a 30-year fixed-rate mortgage?
The first thing investors need to ask themselves is how long do they intend to hang on to the property? This particular question can be addressed by identifying the goals of the investment. Not everyone has the same goals in keeping a mortgage. Some probably plan to build and raise a family in it which usually means they’re in it for the long haul. Others might just be looking for a way to augment their income through rentals, which is most often another long-term goal. And then there are others who are in it for fast money.
If the property, for example, will be used for long- or short-term rental, given the uncertainties of the market and the fluctuation of interest, it might not be a good idea for an investor to go down this route.
However, if the investor is in the business of house flipping, where after rehabilitating the property it will be put on the market, then this setup works really well. As a general rule, the shorter amount of time a person plans to keep the mortgage, the more sense it makes to take an adjustable-rate mortgage.
Investors who want to make the most on this should be prepared to perform their due diligence. They need to look for the best possible housing options, do the math, and connect with the right professionals to make things happen fast.
One of the best advantages of living in a digital era is that research, computing, and connecting can be easily done today compared to how they were done a few decades ago. Taking advantage of different tools online can help investors make wiser decisions faster. Mashvisor is one such tool that can help investors locate the right property, analyze important data, work on computations, and give access to a directory of highly reputable real estate agents with extensive knowledge and expertise on properties and loan types.
Check out Mashvisor to see how we can help you make the most of your investment.
Breaking It Down: What are the Things One Should Look for When Getting a 5/1 ARM Loan?
If a buyer is inclined to get this type of loan, he or she should pay close attention to certain numbers offered by lenders. Let’s break down each number of a 5/1 ARM loan with caps of 2/5/5.
Fixed or Teaser Rate Period
The first number is 5. This specifies how long the fixed rate will be at the start of the term. In this case, we’re looking at 5 years.
Intervals of the Adjustments
The next number, 1, indicates how often the rates will be adjusted once the fixed-rate period is over. The example we’re looking at adjusts its interest rate only once per year.
Initial Cap
The first in the short series of cap numbers is 2 which indicates the limit on the interest’s first upward adjustment. This means that the ceiling for the interest rate in the sixth year should not exceed 2% no matter how the market performs.
Subsequent Adjustments Cap
The second 2 in the cap series of numbers state that can’t go beyond 2% on each adjustment after the first one.
Lifetime Cap
The last number, 5, shows us the lifetime limit on the increase. In this case, the interest rate on this particular mortgage peaks at 5% regardless of how the real estate market performs.
Given the different caps on loans, on the flip side, there are no limitations on an interest rate’s downward adjustment.
A Decade in Review: Looking at 5/1 ARM Loan Rates From 2011 to 2020
When it comes to ARM loans, it’s important for buyers and investors to shop around so they can compare which products will best suit them and their goals. Business Insider published an article earlier in 2021 that contains the lowest rates for the past decade, from 2011 all the way to 2020, according to Freddie Mac:
- 2011 – 2.85%
- 2012 – 2.69%
- 2013 – 2.56%
- 2014 – 2.91%
- 2015 – 2.82%
- 2016 – 2.68%
- 2017 – 3.07%
- 2018 – 3.45%
- 2019 – 3.30%
- 2020 – 2.71%
Notice how between 2011 and 2016 there’s really not much of a difference with the interest rates. The slight differences make it a bit more manageable especially from a budgeting perspective. However, once the rates went beyond 3% in 2017 and almost hit the 3.5% mark in 2018, you can just imagine the financial impact it had on mortgagees.
Those who are seriously considering taking an ARM loan over an extended period should think twice about it before taking the jump. Consult with professionals first before you make any final decisions.
Is the 5/1 ARM Loan a Good Deal for Investors?
At the end of the day, a 5/1 ARM loan may work for some but not for others. It will all depend on a buyer’s goal. If the intent is to keep the property, we suggest looking for other financing options. If the buyer has no intention of keeping the property and plans to move out and sell it within five years, this specific loan type can help keep your costs to a minimum given the lower interest rates. Whatever the goal is, be sure to consult with a credible and reputable professional first before proceeding.
We at Mashvisor are here to help you make the best possible real estate investing decisions. Start out your 7-day free trial with Mashvisor now.