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!? It looks confusing.
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 the 5/1 broken down for you. Disregard that pesky slash.
5/1 ARM Rates Are Lower. That’s the Draw
Well, 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 $312,017.26 versus $315,427.87 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.