Homebuyers who are discouraged by the higher interest rates on fixed-rate mortgages often look to ARMs. However, many are uncomfortable with the idea that the interest rate on today's modern ARMs may change as often as every six months after a short-term fixed-rate period of just a few years comes to an end.
For those folks, it may be that a "throwback" ARM may be a solid choice. The earliest and most traditional ARMs often featured an adjustment interval that matched the loan's fixed rate period, and most of these came in 1/1, 3/3 and 5/5 varieties. The meant that after a one-year, three-year or five-year period the interest rate on the loan adjusted, then remained there for another one-, three- or five-year period.
Because these interest rates adjusted along periodically, lenders offered them at interest rates below -- and often well below -- the rates on the long-term, 30-year fixed-rate mortgages they offered. As lenders typically hold ARMs in their portfolios of loans and prefer higher-frequency adjustment periods on ARMs to better match changing market conditions, traditional ARMs were bypassed by lenders in favor of Hybrid ARMs, such as 3/1 and 5/1 Hybrids, pricing these more aggressively to attract borrowers. Over time, these traditional 3/3 and 5/5 ARMs largely disappeared from the mortgage menu at many lenders.
However, they returned a few years ago, and are in the market today, but not everywhere; you'll need to look for them. Traditional 3/3 and 5/5 ARMs are can mostly be found at smaller, community-based lenders and credit unions.
How does a 5/5 ARM work?
Today's modern hybrid ARMs typically offer a fixed rate for a period of time, followed by interest rate adjustments every six months. A five-year variety would be known as a 5/6m ARM, and conforming versions of these are now usually tied to an index called the Secured Overnight Financing Rate.
A 5/5 ARM will often be tied to a different index, usually the yield for a one-year Treasury Constant Maturity (TCM) or a five-year TCM. This index, plus a markup (called a "margin") will become the loan's new rate when it adjusts.
A 5/5 ARM works in much the same way as other ARMs but with perhaps more security built in. In such a loan, your initial interest rate is fixed for the first five years; then the rate resets to a new rate every five years until the loan reaches the end of its 30-year life, so there are potentially only five rate adjustments over the life of the loan if it is held to maturity. A modern 5/6m hybrid ARM would have 50 rate adjustments after the five-year fixed-rate period ends.
Of course, a low-frequency adjustment period on an ARM carries risks, too. Rates may be fairly low today, but could be higher five years from now, and the interest rate on this ARM would not only move up, but would remain there for the next five years. An ARM with a higher frequency rate change might provide more opportunities for rates to decline over a five-year window, but then again, if rates are in a climbing pattern, higher-frequency rate resets could seem them continue to step higher repeatedly over that time, too.
Conversely, if rates at the time when the 5/5 ARM is taken out are fairly high, as is the case currently, there's a chance that the rate adjustment may come when rates are lower, and you'll lock that lower rate in for the next five years. As with all ARMs, this is the risk you accept in order to get a lower-than-fully-fixed-rate loan today.
Is a 5/5 ARM right for you?
The answer depends on how prepared you are to pay a higher monthly payment five years from now. Consumers who take out a 5/5 ARM today could face paying a higher interest rate in five years, and a sharp rise in rates could see payments lift appreciably.
As an example, let's say a borrower took out a $300,000 loan using a 5/5 ARM with an initial rate of 5.5%; the monthly Principal and Interest (P&I) payment would be $1,703, and after five years, the remaining balance has been paid down to $277,382. The rate is then changed to a 7% rate over a remaining 25 year loan term, which lifts the monthly P&I payment to $1,960 -- another $253 per month, or an increase of more than 15% from just a 1.5% increase in the loan's rate.
That's why borrowers interested in 5/5 ARMs must make sure they can afford the higher mortgage payments when their loan adjusts. Like all ARMs, 5/5 ARMs offer some protection against higher future interest rates, called "caps". However, these limits can vary greatly, ranging from allowing a change of a relatively manageable two percentage point increase all the way to allowing an increase of as much as five percentage points at the first rate change. Although unlikely, such a jump would produce a painful increase in monthly payment.
Related: HSH's Comprehensive Guide to ARMs
How to prepare for a rate increase
If you're considering a 5/5 ARM and are talking to a lender who offers one, be certain to ask about the interest-rate caps, both the per-adjustment and life of loan limits. Then, use a mortgage calculator to run a few worst-case scenarios. What would happen to your mortgage payment if your rate shot up by two percentage points after five years? What about 5 percentage points? Could you afford that monthly payment?
Of course, an interest rate increase of 5 percentage points percent is a worst-case scenario, and an unlikely one. But a smaller increase is very possible, so you should also run more realistic scenarios, where rates adjust by one to three percentage points after the 5-year fixed-rate period ends. Can you still afford your monthly payment after that increase, or do you think it may be uncomfortable? Consider that your income in five years may be different -- and hopefully higher, improving the manageability of a payment hike -- or not.
If you're afraid you can't afford your loan after the rate adjusts, you probably shouldn't go into a 5/5 ARM no matter how enticing that initial interest rate may be. And no, jumping into one today with expectation that you'll be able to refinance to something more fixed at a lower rate in the next five years isn't something you can count on. If the rates that govern ARMs are higher when the rate comes due to adjust, it's a near certainty that the rates on long-term fixed-rate mortgages will also be higher.
ARM rates can go down, too
Those same caps that limit the upside for the loan's interest rate usually apply when rates are falling, too -- that is, the interest rate won't fall by more than perhaps two percentage points at any adjustment, and can't decline more than five percentage points from the starting interest rate. Such a decline would be a best-case scenario, albeit a highly unlikely one.
5/5 ARMs fit some borrowers well, others not so much
While there can be advantages to a 5/5 ARM, not that many borrowers are interested in ARMs of any kind. It's also true that, for a variety of reasons, lenders aren't pricing ARMs as aggressively as they did in the past, so the interest-rate break for taking one isn't as wide as it once was.
But a lower interest rate has the most impact on a borrower's payment when the loan amount is high. We used a $300,000 example above, but if the loan amount was $1,000,000, even a modest interest rate break attained by selecting an ARM can bring real cash-flow (and cost-saving) benefits. A $1,000,000 "jumbo" 30-year FRM with an interest rate of 6.5% would carry a monthly P&I payment of $6,321; the same loan amount with a 5.5% rate that might be found on a 5/5 ARM carries a monthly payment of $5,678 - a differential of $643 per month.
Over the first five-year window, the 30-year FRM would see the borrower pay $315,351 in interest, where the 5/5 ARM with a 5.5% rate would be $285,279 -- more than $30,000 lower. At the same time, the lower interest rate means a faster repayment of the loan principal, too -- the remaining balance on the 30-year FRM after 60 payments would be $936,110 versus the $924,606 on the 5/5 ARM with the lower rate. With savings and differentials in costs such as these, it's not hard to see why jumbo borrowers are often attracted to ARMs.
That doesn't mean the smaller savings amount generated with a smaller loan amount doesn't have value; it does, so even borrowers buying more typically priced homes can garner some savings. At the same time, it's also more likely that someone whose income will support a million-dollar mortgage can manage a higher future monthly payment, and so are better able to accept the risk that one may come.
So should you consider and even select a 5/5 ARM to finance your home purchase? You should certainly consider it, but need to be aware of the risks and how they apply to your circumstance before actually selecting one. If one fits your situation, finances and time frame, a 5/5 ARM can be a way to get yourself some mortgage savings.
