Adjustable-Rate Mortgages (ARM) can sound like a risky option since payments can decrease or increase based on the interest rate, which you have no control over. However, in some cases, a hybrid ARM may actually be a great option for your financial situation. A 5/1 ARM has an initial period of five years where the interest is fixed, at which time the interest will then adjust annually. Most borrowers who pick a 5/1 ARM want to move or refinance before the fixed interest-rate has expired. However, this can be a risky move due to the fact that general market conditions or personal finances can make refinancing or moving extremely difficult or sometimes even impossible. In order to determine if a 5/1 ARM is best for your situation it’s important that you look at both the pros and cons.
Con: Some 5/1 Arms Has a Prepayment Penalty
There are some 5/1 ARM loans that have a prepayment penalty. This fee will be tacked on if you refinance or sell your loan. This means that if you want to sell your house or refinance it within the fixed initial period of your mortgage then you should make sure that you ask your mortgage lender about finding a loan that doesn’t have this penalty.
Pro: You Can Save a Substantial Amount of Money
You may end up saving big bucks in the five years that the interest rate is fixed on a 5/1 ARM. For instance, if the 5/1 ARM has an APR of 2.9% and you take out a $240,000 mortgage, and put down $60,000 then the total interest payments and monthly principal will come out to about $996. This means that in the first five years of paying off your mortgage, you already will have paid off $27,114 just in principal. On the other hand, if you got a fixed-rate mortgage for 30 years with an APR of 4.3% then your total interest payments and monthly principal would amount to $1,188, which is $191 more than the 5/1 ARM. This means that in the first five years of your mortgage, you’d end up saving $11,501 in interest payments and in principle by choosing the 5/1 ARM.
Con: Your Payments Can Increase
If your interest rate becomes higher after the initial rate period is over then your payments will increase. If you can’t take that financial hit then it can end up with you getting what’s called “payment shock” and not being able to make your payments and thus defaulting on your loan. This is a substantial risk that you must take if you want to live in your house once the initial fixed-rate period comes to an end.
Pro: There’s an Interest Rate Cap
Many 5/1 ARMs will have an interest-rate cap, which will place a limit on the amount that the interest can increase. It’s important that you ensure that the 5/1 ARM you decide to take out has this periodic adjustment cap, as it’ll mean that the amount your rate can be adjusted from one period to the next will be limited to a certain amount. Some 5/1 ARMS have a lifetime cap, which will limit the amount that the interest rate can increase during the loan’s life.
Con: Interest Rates Will Likely Increase
The Federal Reserve has recently stated that they are planning on raising interest rates in the coming months, and have even held a presentation which outlined a few approaches to increasing short-term interest rates once it becomes appropriate to do so. Due to this, when deciding if you want to take out a 5/1 ARM, it is best to keep in mind that in all likelihood your interest payments will increase after the fixed initial period, and so it is best that you base your decision on an increasing interest rate scenario and not one where the interest rate becomes lower after five years. This may make fixed-rate mortgages more attractive than a 5/1 ARM, especially to those who want to remain in their house for longer than the five-year initial period.