An Adjustable Rate Mortgage (shortened to ARM) is a mortgage where the interest rate on the mortgage varies. In an ARM, there is an initial period of a fixed rate, then the interest rate changes. When compared to a fixed rate mortgage, an adjustable rate mortgage differs because the interest rate will change over time to match the market. Specifically, banks will link the interest rate on an ARM with certain indexes.
Each ARM is defined by a few major criteria. First of all, the initial interest rate and the initial interest period. The initial interest rate on an ARM will be defined by the bank. As a general rule, this interest rate will be lower than a fixed rate mortgage, in order to make the ARM more attractive to customers. The initial interest period is the length of time that this fixed interest rate will be applied. In a 5-1 ARM, the 5 indicates that the initial interest period is five years long.
The next major part of an ARM is how the interest rate will change. In an 5-1 ARM, the rate will change every 1 year. If a mortgage were a “5-2” ARM, the interest rate would change every 2 years. The change of the interest rate will depend on what the ARM is linked to. If the index that the ARM is linked to has increased, then the rate of interest on the mortgage will increase, and the mortgage will become more expensive overall.
Because the economy generally improves over time, an ARM usually will cost more, not less, than its original fixed rate. A fixed rate mortgage is generally a better option for home-buyers. At this time, fixed rate mortgages are at incredibly low interest rates due to the financial downturn. There is not really any reason one would go with an ARM instead of a fixed rate right now.
In addition to the increase in cost over time, ARM’s have also had a bad reputation with errors. Banks admit that “up to 50% of ARM’s” are miscalculated, causing homeowners to pay more than they should.
Mary Cass, Member
A 5-year ARM (also referred to as a 5/1 ARM) is a certain kind of ARM. An ARM, which stands for adjustable-rate mortgage, is a type of mortgage where the interest rate fluctuates with a given index (such as the LIBOR or CD indices). This differs from a fixed-rate mortgage, where the interest rate stays constant over the life of a mortgage.
Most ARMs offer an introductory period with a fixed interest rate. After the introduction rate expires, the interest rate will be reset after a certain period of time. A 5/1 ARM means that the loan will have a fixed interest rate for the first 5 years of payments. After that, the interest rate will be reset once a year. Similar ARMs include a 3/1 or a 7/1 ARM, which would have a fixed rate of interest for the first 3 or 7 years and reset annually thereafter.
You may notice that the introductory rate for ARMs is lower than the interest rates on most fixed rate mortgages. This is because there is more risk involved in an ARM. If the index has risen after the introductory period is up, your interest rate will rise as well (and may continue rising over the life of the loan).
Because of the uncertainty involved with an ARM, most buyers will look for a fixed-rate mortgage, unless they only plan to live in the property for a few years. In this case, an ARM can actually be advantageous for the buyer, who can take advantage of the low interest rate for the first several years and resell or refinance before the rate changes.
Other numbers to consider when looking at an ARM: the margin, which is the amount added to the index to calculate your interest rate, and payment caps, to protect against rising rates (some loans offer one, some do not).
Jeff M., Member
A five-year ARM or adjustable-rate mortgage essentially locks in a lower rate for a consumer for five years and then the rate will fluctuate. In the case of a 5/1 ARM, the rate will then change every year after that five-year period is up. The loan is attractive because it can lower payments and rates for the first years, but the issue comes when that initial period is up. At that point, there is usually a cap on how much the rate can go up or down per year.
The fixed-rate mortgage gives you more guarantees, the adjustable-rate mortgage is more of a risk. For customers looking to own for only a short period of time and then sell within that five-year time frame, it can be a better option to pay less in interest during that period. But as it has been stated before, there is a risk if the property is still owned and the mortgage is in place after five years that the rate can go much higher. Essentially, there are few guarantees and the customer is more subject to market fluctuations than otherwise.
The reason that banks offer these adjustable-rate mortgages is that they can then be less suspect when market fluctuations occur. Banks with many 20 or 30 year fixed loans at rates below prime are worse off than banks that offered five-year ARMs and then the rate fluctuated after that time to meet the current market, essentially ensuring for the bank that it would receive current market value for loans.
Customers, on the other hand, can look at a five-year ARM as a good start on a loan with a lower rate. If there is adequate principal paid off within that five-year span, they can look to refinance that mortgage after five years to a better fixed rate based upon the money already put down on the property. The difference between a 5/1 ARM and a 5/5 ARM is how often that rate fluctuates. The first number (5) is how long the initial rate is good for and the second number (1 or 5) is how often (every 1 or 5 years) the rate will change.
Dave Skow, Sr Loan Officer
this is a loan that is amortized for 30 yrs ..the rate/ payment are fixed for the 1st 5 yrs ..at the start of the 6th yr - the rate/ payment will adjust ..this adjustment will then occur every 12 month
Miranda Marquit, Member
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.
"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." If I choose and qualify for a 5/1 ARM, how do I find out if I will also qualify for the 15-year fixed rate mortgage at the end of the five years?
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