5/1 ARM vs. the 30-Year Fixed : Pros and Cons

June 24, 2011 50 Comments »
5/1 ARM vs. the 30-Year Fixed : Pros and Cons

Here we go again…it’s that special time where I compare two popular loan programs to see how they stack up against each other. Today’s match-up: “30-year fixed vs. 5/1 ARM.”

Everyone has heard of the 30-year fixed-rate mortgage – it’s far and away the most popular type of loan out there. Why? Because it’s the easiest to understand, and presents no risk of adjusting during the entire loan term.

But what about the 5/1 ARM? Do you even know what a 5/1 ARM is? What the heck is that slash doing there!? This looks confusing…

5/1 ARM

Put simply, the 5/1 ARM is an adjustable-rate mortgage with a 30-year term that’s fixed for the first five years and adjustable for the remaining 25 years. That means it’s a hybrid ARM. Partially fixed, and partially adjustable.

After the first five years are up, the interest rate can adjust once annually, both up or down. That’s where the 1 comes in, as in one adjustment per year. Whew, there you have it, 5/1 broken down into terms we can all understand. Oh, and disregard that pesky slash.

It’s a pretty popular ARM product, if not the most popular. And as such, just about all mortgage lenders offer it. So you won’t have any trouble finding it. That also means you can comparison shop quite easily.

5/1 ARM Rates Are Lower. That’s the Draw

30 vs 5/1 rates

The biggest advantage to the 5/1 ARM is the fact that you get a lower mortgage rate than you would if you opted for a traditional 30-year fixed.

As you can see from the chart I created above, the 5/1 ARM is always cheaper than the 30-year fixed. That’s the trade-off for that lack of mortgage rate stability.

But how much lower are 5/1 ARM rates? Currently, the spread is 0.63%, with the 30-year averaging 3.78 percent and the 5/1 ARM coming in at 3.15 percent, per Freddie Mac data.

Since Freddie began tracking the five-year ARM back in 2005, the spread has been as small as 0.27% and as large as 1.30% in 2011.

If the spread were only 0.25%, it’d be hard to rationalize going with the uncertainty of the ARM. Conversely, if the spread were a full percentage point or higher, it’d be pretty tempting to choose the ARM and save money for at least 60 months.

Let’s look at an example of the potential savings:

Loan amount: $350,000
30-year fixed monthly payment: $1,626.87
5/1 ARM monthly payment: $1,504.08

So you’d be looking at a difference in monthly mortgage payment of roughly $122, or $1,464 annually ($7,320 over 5 years), using our example from above. Not bad, right?

You’d also pay down your mortgage faster because more of each payment would go toward principal as opposed to interest. So you actually benefit twice. You pay less and your mortgage balance is smaller after five years.

After five years, the outstanding balance would be $315,427.87 versus $312,017.26 on the five-year ARM. That’s roughly another $3,400 in savings for a total benefit of nearly $11,000.

Discussion over, the ARM wins! Right? Well, there’s just one little problem…

It might not always be this good. In fact, you might only save money for the first five years of your 30-year loan.

After those initial five years are up, you could face an interest rate hike, meaning your 5/1 ARM could go from 3.25 percent to 4.50 percent or higher, depending on the associated margin and mortgage index.

ARMs Are Cheap But Will Likely Head Higher

Currently, mortgage indexes are super low, but they’re expected to rise in coming years as the economy gets back on track, which it will eventually.

And you should always prepare for a higher interest rate adjustment if you’ve got an ARM. In fact, lenders typically qualify you at a higher rate to ensure you can make more expensive payments in the future should your ARM adjust higher.

So that’s the big risk with the 5/1 ARM. If you don’t plan to sell or refinance before those first five years are up, the 30-year fixed may be the better choice.

Although, if you sell or refinance within say seven or eight years, the 5/1 ARM could still make sense given the savings realized during the first five years. And most people either sell or refinance within 10 years.

Just be sure you can actually handle a larger monthly mortgage payment should your rate adjust higher. And realize that refinancing won’t always be an option – you may not qualify, or rates may be too expensive to justify a refi. It’s never a guarantee.

If you actually plan to pay off your mortgage, an ARM could be a bad idea unless you seriously luck out with rate adjustments. Or you serially refinance and pay extra to shorten the amortization period. Otherwise, there’s a good chance you’ll pay a lot more than you would have had you gone with the 30-year fixed.

Why? Because each time you refinance to another ARM, you’re getting a brand new 30-year term. That means more interest is paid over a longer period of time, even if the rate is lower.

However, if you’re a savvy investor and have a healthy risk-appetite, the 5/1 ARM could mean some serious savings, especially if the extra money is invested somewhere else with a better return for your money.

Five years not enough for you? Check out the 30-year fixed vs. the 7-year ARM, which provides another two years of interest rate stability. The rate may not be as low, but you’ll get a little more time before that first rate adjustment.


50 Comments

  1. Colin Robertson November 16, 2017 at 10:03 am -

    Joseph,

    Actually you could argue that you have more than five years to make a move because the savings realized during those first five years allow for a buffer even if rates rise.

  2. Joseph Squires November 16, 2017 at 1:19 am -

    Inflation is a big concern for the upcoming 20 years ($15 minimum wage, etc., etc., causes money to be “worth less”). ALWAYS go with a fixed rate.

    ONLY go with a 5/1 ARM if you plan to sell the property after 3 years (not 5 years… because if nobody would purchase the property your rate would more than likely increase) OR

    ONLY go with a 5/1 ARM if you have a friend or family member who would also get a property and trade properties with you after each 5 years (basically only if you sell the property). This way, though, you and your friend could still have ownership of the properties at low monthly payments

  3. Joseph Squires November 16, 2017 at 12:46 am -

    Koree,

    I’m no expert, but the knowledge you have on the subject makes sense to me also (they are confused as to what it should be). People get over on others.

    The only logical explanation is that somebody would choose that option of the 5/1 ARM to pay off the mortgage “faster” by paying more sooner and have to pay less later.

  4. Koree June 5, 2017 at 2:45 pm -

    How is the APR on an ARM higher on a purchase than a fixed rate APR?? I’m confused why an ARM would be higher, when on my purchase, I’m not wrapping in any closing fees, I’m coming to closing with all the down payment and closing fees. If APR, indeed is the “cost of doing the financing”

  5. Colin Robertson June 3, 2017 at 10:47 am -

    Deborah,

    They aren’t taking the remaining balance and amortizing over the remaining period with the new fully indexed rate?

  6. Deborah June 2, 2017 at 3:08 am -

    Hi Colin, I currently have an adjustable 5/1 and have been paying additional principal since day one. Regardless of the interest my payments starting year 6 have decreased when the annual adjustment in interest is calculated. In 2015 the rates remained the same and thus my mortgage payment also stayed the same for a two year period. My question is why would the bank not recalculate my principal and the same interest rate to reset as it does each year? I feel that the bank has made a mistake in not assessing the principal balance and it has cost me about 1,000 in interest that should have been recalculated. Not one person from the lending department can give me a solid response.

  7. Colin Robertson May 23, 2017 at 8:35 am -

    Cindy,

    It should reamortize based on the remaining term and new interest rate. For example, if there are 25 years left you’d plug in 300 months and then the new rate (3%) to calculate the new payment. You can also ask your servicer directly to be sure. For a 5/1, this new rate should remain in effect for 12 months before its next adjustment. That’s where the 1 comes in…annually adjustable after five years of fixed payments.

  8. Cindy Smith May 22, 2017 at 12:58 pm -

    Hi Colin, I have a 5/1 arm loan which has had 2.125% interest rate for a few years. :-) It has incresed to 3% and I am curious what my new adjusted payment will be in Aug. Is there a way for me to figure that out? Also, do you know if my payment will stay the same for the entire year?

  9. Colin Robertson May 9, 2017 at 7:33 am -

    Jay,

    There’s no rule against it and I’m sure people do it, but you have to be mindful of closing costs each time and understand that you’re resetting the amortization back to 30 years over and over. If you keep doing it you’ll find that you pay more interest over time.

  10. Jay May 8, 2017 at 11:49 pm -

    Colin,

    Great article. Explains a lot. I am a big risk taker, and I am pretty sure I can handle the cost if it goes up in 5 years. My question is, is it possible to refinance a 5/1 ARM every say 5 years for another 5/1 ARM or is that frowned upon?

    Thanks,

  11. Colin Robertson May 2, 2017 at 7:40 pm -

    Dave,

    Like I’ve mentioned to others before, the downside or risk is that you may not move as planned. As we all know, plans change. And if you stay put and your ARM happens to adjust significantly higher it could hit your wallet. But if you’re fairly certain you’ll move, you could potentially save some money with the 5/1. The 30-year fixed essentially provides security for the what-if, for a price.

  12. Dave L. May 2, 2017 at 6:18 pm -

    Colin,

    We are looking to re-fi our current mortgage and cannot decide if it’s better to go with a 5/1 ARM or a 30 Yr Fixed option. We plan on selling our home within the next 2 years. We are considering the 5/1 ARM over the 30 YR Fixed because I lost my job recently that paid 3 times what I am making currently. We are looking to eliminate some of our credit card debt while also decreasing our montly mortgage payments. Would you suggest we do the 5/1 ARM or continue to re-fi with another 30 YR Fixed option? What is the downside, if any, to us moving forward with a 5/1 ARM instead if we do plan to sell our home within the next 2 years?

    Best Regards,
    Dave L.

  13. Colin Robertson April 3, 2017 at 5:50 pm -

    Walter,

    Sure, those are good considerations to go with a 5/1 ARM. And you do note that if rates rise your prior savings will provide a buffer. The only real hitch with these things is if for some reason you’re completely unable to refinance in the future and rates surge higher.

  14. Walter L. April 1, 2017 at 7:22 am -

    So I’m being relocated and am shopping for a mortgage for the new home. I’m considering 5/1 ARM for a few reasons: 1) I will be paying a lower interest rate for the first 5 years while my principal is high 2) once I sell my old home within a year I will initiate a curtailment to lower my principal 3) even if rate increases, it would be against a largely reduced principal 4) the mortgage interest I’ll be paying is tax-deductible 5) As last resort I can refinance depending on market situation.

    Are these reasons valid for seeking 5/1 ARM, or am I overlooking something? Thanks.

  15. Colin Robertson March 29, 2017 at 9:49 am -

    Dory,

    If you just need the mortgage for a short period of time and can pay it off in full, products like the 5/1 ARM are great because they’re fixed for that first five-year period and are priced lower than the 30-year. So you save money each month, pay down the loan faster, and ideally pay it off before it resets higher.

  16. Dory March 29, 2017 at 8:09 am -

    Colin,

    We are getting close to retirement and have started looking for a place to purchase. I found one that looks good financially…$55900. Need some work but we are fine with that. So we won’t sell our house until my husband retires in about 2.5 yrs at that point we could payoff the new mortgage. Would a 5/1 arm be the best way for us to go?

  17. Colin Robertson March 3, 2017 at 10:20 am -

    Matt,

    The potential downside is if rates keep rising, your rate can keep climbing. I’d check on that 1% max increase after the first reset…usually the caps are 2% or higher. But a 1% initial rate cap could certainly limit the damages. Still, the rate could then rise another 1% the following year once the next adjustment hits and so on if you didn’t refinance again or sell. The other possible downside is if for some reason you’re unable to refinance and wind up stuck in the ARM. But the upside is the savings you mentioned…may want to compare it to the monthly savings with a fixed loan as well if you’re unsure about the ARM.

  18. Matt March 2, 2017 at 3:38 pm -

    Hi Colin,

    I am currently 2 yrs in to a 30 yr fixed and trying to find ways to lower my monthly mortgage payment. I just discussed a 5/1 with my mortgage broker, he said it would reduce my monthly payment by about $460 a month, which translates to over $5K of savings in a year. I was told that, after 5 yrs, the APR could increase by no more than 1% (or decrease by no more than 1%) if I wanted to stick with it. Or, I could refinance. It seems like a good option, but wondering what the potential downside could be?

  19. Colin Robertson February 8, 2017 at 7:31 pm -

    Ashraf,

    It depends on other attributes of the loan, such as credit score, property type, and if you pay points or get a credit. Could be quite a range, but rates for those types of ARMs these days might range from the mid-3s to the mid-4s for LTVs that high.

  20. Ashraf Mehdi February 8, 2017 at 4:23 pm -

    Hi Colin
    My Loan amount is 445K after 5% down Payment.
    Can I go for 5/1 ARM or 7/1 ARM using Jumbo loan.
    if yes, what will be interest rate.

  21. Colin Robertson January 24, 2017 at 10:00 pm -

    Ed,

    The downside would be if you are somehow stuck with the home after five years and the payment goes up significantly on the ARM at reset and 30-year fixed rates are also much higher. The upside is if you sell around five years or less you save monthly via a lower interest rate.

  22. Colin Robertson January 24, 2017 at 9:58 pm -

    Debashis,

    As stated in the article, one of the pros of a 5/1 ARM is the lower interest rate, but it may reset higher after five years. At that point, you’d need to refinance (assuming you qualify for a mortgage at that time) or deal with the higher payments, assuming the payment resets higher. The 30-year could also be higher at that point, meaning you’d be stuck with a higher rate in either scenario, but it could also be lower or not much higher, meaning it’s a risk you can take for a potential reward. Your expected tenure and risk appetite definitely come into play.

  23. Colin Robertson January 24, 2017 at 9:47 pm -

    Mark,

    Right, here in the States we tend to have longer fixed-rate mortgages, with the shortest generally a 10-year fixed. My assumption is in AUS these fixed loans are refinanced at the end of the term, not actually paid off in full in just five years, kind of like how a 5/1 ARM would likely be refinanced into a new loan after five years, or sometime before that first reset (higher). In both cases, the loan isn’t paid in full, and new financing is needed, unless the ARM borrower is happy with the fully-indexed rate.

  24. Ed January 21, 2017 at 8:36 am -

    Colin,

    My wife and I are buying a investment home we will rent to our daughter and her husband until they sell their home.

    They currently live a few states away, own their home that is also an investment property (duplex) but have had difficulty selling because they live in a small community. They will have no difficulty renting the unit they now live in.

    The initial plan is that they either buy the home from us within 3-5 years or we sell it and they buy another home.

    The bank has suggested in addition to a 30-year loan, we look at the 5 year ARM–I am leaning that well as well. Do you see a downside?

  25. Debashis Roy January 19, 2017 at 1:23 pm -

    Hi Colin,

    I’m trying to buy my first home in the US. The purchase price is 662K. Its a presale having an estimated closing around 1st week of April,2017.
    I have been shopping mortgage recently and am getting very good rates for a 5/1 arm. But reading all the comments above, I’m not sure which way to go, since I’m planning to stay here for at least 20 years and I also want to have lower monthly payments.
    Kindly let me know if it will be a good option to go for a 5/1 now and refinance it later to a fixed rate(if that is possible). Also, what should I know about refinancing.
    Regards,
    Debashis

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