There are a number of different types of mortgages. Keeping them all straight can be confusing. Which kind is the best for you? Which one will cost you the least amount of money? Well, the two most basic types of mortgage are fixed rate and adjustable rate. A fixed rate mortgage sets your loan at one particular interest rate, which doesn’t change over the entire course of the mortgage. An adjustable rate mortgage (ARM) can have its interest rate raised or lowered at certain times, based on the fluctuations of interest rates in general.
If you’re getting a mortgage when interest rates are especially low, a fixed rate mortgage is a good option, as it will allow you to lock in the lower rate and not have to worry when they start to rise again. An ARM is a better option when rates are higher, as you can have the opportunity to lower your rate later on.
But what about a 5/1 ARM? That’s when your mortgage’s interest rate is fixed for the first five years, and then can be adjusted once every year thereafter, for the duration of the mortgage. When is a 5/1 ARM a good idea? What are the advantages and disadvantages? Here are five things you need to know.
- Lower Monthly Payments. One advantage of ARMs is that they offer a lower initial monthly payment than a fixed-rate mortgage, allowing you to get a larger amount for cheaper. The initial interest rate is usually lower than for a fixed-rate loan as well. However, if your interest rate increases, your payments will increase as well.
- Caps. Often, an ARM will come with a specific cap, expressed as three numbers. This keeps your interest rate from potentially ballooning out of control. Say your cap is 4/2/7. This means that, after your five year fixed-rate period is over, the first adjustment can’t raise the rate more than 4%. Then, each subsequent adjustment can’t raise the rate by more than 2%. And the total interest rate can never go higher than 7% above your starting rate. Look at the cap before getting a 5/1 ARM.
- Equity. If your interest rate goes up, it can slow the accumulation of equity in your home. This can make it difficult to refinance your home down the line.
- Fast Turnaround. So who would best benefit from a 5/1 ARM? The main type of people are those who plan on selling their home within a few years of buying it. If they’re still within the five year fixed rate period when they sell, they can avoid rate increases, while still benefiting from the lower rate and lower payments of an ARM.
- Other Options. If a five year fixed rate isn’t enough, you can also get a 7/1 ARM, or even a 10/1 ARM, which locks your interest rate in for longer. If you expect interest rates to go up rather than down over that time, then these longer fixed rates might be worth looking into.
So, should you get a 5/1 ARM? It can be a good move and can save you money, but it’s also a gamble. If interest rates go up, you’ll end up paying more. Look at your own financial situation: where you are now, where you plan to be in five years, and what kind of interest and payment options you need. Then talk to an expert and decide whether a fixed-rate mortgage or ARM is the best fit for you.