I'm looking at different mortgage loans, and I've seen some offers for a 5/1 ARM? What does that mean?
When you begin considering your mortgage options, one of the loans you might run into is the 5/1 ARM. This is a loan that starts out with a five-year fixed rate, and then switches to a variable rate, which changes once a year during the remaining years of the loan. That is what the 5/1 means: The loan is fixed for the first five years, and each year after that, the interest rate adjusts. The fact that the interest rate (and your monthly payment) only changes periodically therefore gives a 5/1 ARM a level of stability relative to other ARMs, which have rates that may change on a monthly or semiannual basis.
The 5/1 ARM can be an attractive mortgage option because it often starts with a fairly low interest rate. The introductory interest rate is usually lower than what you would see with a fixed rate loan – sometimes by as much as a full percentage point. However, you should be prepared for the fact that when the five-year fixed-rate period ends, your interest rate, and your monthly payment, could rise. Most ARMs come with a cap. This cap can either be a periodic cap, which limits the amount that the rate can rise each interest period (often quarterly or annually), or a lifetime cap, which limits the total increase for the interest rate over the lifetime of the loan.
Many homeowners start with a 5/1 ARM intending to refinance to a fixed-rate loan before the initial period expires. Freddie Mac reports that the average pay off period for mortgage loans is a little less than four years. This means that many owners either sell or refinance (or foreclose) within this time period. Even during 2008 and 2009 when that average bumped up, it still remained less than five years. To be able to refinance you will need to have a certain amount of equity in your home; if refinancing is your plan, you should figure out the loan you want to eventually take and make sure you will qualify for it under your current schedule.