5/1 ARM vs. 30 Year Fixed Mortgage
Point of Interest
Whether you choose a 30-year fixed mortgage or a 5/1 ARM loan when buying or refinancing a home will depend on a ton of factors, including your budget, how high mortgages rates are when you’re applying and how long you plan to stay in the house.
Buying a home is a confusing process already, and then you have to pick a type of mortgage. You have several options, including an adjustable-rate mortgage (ARM) and a 30-year fixed loan. But what does all this complicated jargon mean?
In layman’s terms, the big difference between the two is whether or not your mortgage rate — or the percentage of interest you pay on your home loan — will ever fluctuate. ARM loans, or adjustable-rate loans, have interest rates that can fluctuate with the economy after a certain period of time. Fixed-rate mortgages do not.
The 5/1 ARM vs. 30-year fixed loan debate can be confusing, but luckily, once you understand the pros and cons of each type of loan, you should have no problem deciding which loan is right for you.
What is a 5/1 ARM?
A 5/1 adjustable-rate mortgage isn’t as complicated as it sounds. Basically, you get a low interest rate locked in for the first five years of homeownership. The rate doesn’t change for the first five years. Once that five-year fixed term is over, your mortgage transitions to a flexible interest rate that can change once per year. This new rate changes every year.
Why would you want your interest rates to change? Some home buyers prefer this type of loan when home loan interest rates are high overall and there’s an anticipation to drop in the future. That way, you have a chance of lowering your rate after the first five years and taking advantage of any falls that come about.
Another convenient time to apply for a 5/1 ARM is when you plan to move in five years or less. Maybe you have a temporary job or are relocating for a few years to be near a sick relative. You’ll get a rate reduction for the first five years, which can help you save money if you plan to refinance or sell your home before the rate starts adjusting.
Of course, there’s a risk of rates increasing rather than falling with this type of loan, but there is a cap for the percentage it can increase each year. The rate cap determines how much it can increase year over year, or how many dollars it can rise, depending on the loan.
The typical 30-year mortgage
A traditional 30-year fixed mortgage is the most popular choice for borrowers. This type of loan has a fixed interest rate agreed upon at the start of the loan that lasts for the entirety of the mortgage. Many borrowers try to lock in a low rate for 30 years to ensure they will know what they owe on their mortgage until they pay it off. The locked-in rate will never fluctuate, guaranteeing security, even in times of market instability.
Pros and cons
- Borrowers receive a lower intro rate for the first five years.
- If rates decrease after your first five years, you could see yours go down.
- Rate increases are capped for how much it can rise over time.
- Rates could increase after your first five years, causing you to pay much more over time.
- Even with a rate cap, the increase is largely out of your control.
- You might owe a prepayment penalty if you pay off your loan early.
- Your interest rate is locked in for 30 years.
- Your monthly payment will remain steady.
- The loan contract is more straightforward than the 5/1 ARM.
- It’s the most common type of mortgage.
- You can’t change your mortgage rate, even if rates drop, unless you refinance your loan.
- You don’t get the initial rate reduction like the 5/1 ARM offers.
Other common adjustable-rate mortgages are the 10/1 ARM, the 7/1 ARM and the 3/1 ARM. The difference is in how many years the initial rate stays locked.
How to choose?
There are two main circumstances that make sense to justify applying for a 5/1 ARM. The first one is when interest rates are high and will likely fall within five years. Your low interest rate is locked for the first five years, but you’ll have the flexibility to take advantage of falling rates if they come around after the intro period ends.
You could also consider a 5/1 ARM if you’re not planning to stay in your home for more than five years. You can still take advantage of the initial rate reduction while not having to worry about potentially paying more each month when the rates fluctuate. However, keep in mind that if your plans change or you can’t sell your house quickly, you may be stuck paying a higher interest rate for a while.
If you don’t fall into either of these two categories of homebuyers, you might be better off going with a 30-year fixed mortgage. Rates are low right now, so crossing your fingers for them to drop more in five years might not be a realistic bet.
The final word
If you’re debating the 5/1 ARM vs. 30-year fixed mortgage, only you can decide what’s right for your situation. It might be a smart go with a 30-year fixed loan at the moment since mortgage rates are at near-historic lows and are expected to continue falling during the coronavirus pandemic. If you want to opt for a 5/1 ARM with the hopes that a further drop will happen, just remember that you could end up paying significantly higher rates after your five years of fixed interest is up.
On the other hand, you could look into a 7/1 ARM or 10/1 ARM that has a similar low initial rate advantage but a longer fixed period. This type of loan might be less of a risk if you have your rate locked in for seven or 10 years.