30-Year Fixed vs. 5/1 ARM

June 24, 2011 38 Comments »
30-Year Fixed vs. 5/1 ARM

Here we go again…it’s that special time where we 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!?

Put simply, it’s 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.

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.

It’s a pretty popular ARM product, and most mortgage lenders offer it, including ING, via its Easy Orange Mortgage.

So what’s the draw of the 5/1 ARM?

30 vs 5/1 rates

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? Currently, the spread is about 1.25%, with the 30-year averaging 4.50 percent and the 5/1 ARM coming in at 3.25 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 1.15% in 2014.

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: $1,773.40
5/1 ARM monthly payment: $1,523.22

So you’d be looking at a difference in monthly mortgage payment of $250, or $3,000 annually ($15,000 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 $319,052.60 versus $312,573.78 on the five-year ARM. That’s roughly another $6,500 in savings for a total benefit of nearly $22,000.

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 Low 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.

[Why adjustable-rate mortgages are bad news right now.]

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 fist 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.

If you plan to actually 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.

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.

38 Comments

  1. Belinda Hughes November 3, 2015 at 12:32 pm -

    Colin,

    I am 50, single and own my own home with a 30 years mortgage and I in 7 years in. I am considering a re-fi to a 5/1 Arm Loan to paid off in 5 years. I then want to sell and repurchase a different home using the proceeds from the sale. In your opinion, does the 5/1 make sense in this situation? If not, please explain

  2. Colin Robertson November 9, 2015 at 3:49 pm -

    Belinda,

    A 5/1 ARM has a 30-year repayment period, it’s just fixed for the first five years and adjustable for the remaining 25 years. So not sure that would accomplish what you’re looking to do.

  3. Chrystal November 24, 2015 at 9:35 am -

    Can a 5/1 typically be paid off at 5 years or before without penalty? If we were to refinance at the 5/1 arm rate we could stack enough extra on the principle to pay off the balance within the 5 years. Basically, can you make extra principle payments on a 5/1 arm loan and pay it off early? Are there typically penalties for that?

  4. Colin Robertson December 1, 2015 at 12:05 pm -

    Chrystal,

    Yes, as long as there isn’t a prepayment penalty, which aren’t as common these days.

  5. nancy February 3, 2016 at 11:25 am -

    Hi Colin – We’re both in our 50’s and relocating to CA from AZ. We’re selling a house with a 30-year term at a horrible interest rate (never refinanced because we kept thinking we’d just sell) and now we don’t know what kind of mortgage we should get when we re-purchase in CA. We’re going down to one steady income from two while I freelance. We’re computer people, not finance people!

  6. Colin Robertson February 3, 2016 at 2:49 pm -

    Nancy,

    Sounds like you’ll probably have to get a 30-year loan (as opposed to 15) if on a single income and moving to expensive California from much cheaper Arizona. You can go with an ARM as well (that also has a 30-year term) but the rate will only be fixed for some period of those 30 years, such as three, five years, seven, etc. The big risk is that it can adjust higher…the benefit is you get a lower rate and could sell/refinance before it ever adjusts. The choice is yours. Good luck!

  7. Hector February 10, 2016 at 11:45 am -

    Hi Colin,

    My wife and I are looking to purchase our first home with a VA loan. We, along with her mother who will live with us, will have a combined 3 incomes. The house is 250,000. We are unsure about whether to go with a 5/1 ARM or 30 year fixed. We do plan on making this our family home. However, we do not yet have much reserve funds. Would it be advisable to start with a 5/1 ARM and then refinance? What would be the best course of action?

  8. Jim February 10, 2016 at 8:57 pm -

    Hi Colin,

    My wife and I are two years or so into a 15yr fixed at 4% and are paying extra…we’re on pace to pay off the 230k balance in 6yrs. Does it make sense to refi to an ARM or any other type of loan to chip away at it even faster or cheaper?

    Thanks.

  9. Colin Robertson February 11, 2016 at 3:45 pm -

    Jim,

    It’s possible it could save you money…or even a 10-year fixed with a lower interest rate. Just gotta do the math and consider the fact that if you do refinance to an ARM you’ll be at the mercy of a rate reset if you don’t pay it off as quickly as you plan to.

  10. Colin Robertson February 11, 2016 at 4:01 pm -

    Hector,

    The ARM might be cheaper now but that could change, and if you really plan to make it your “forever home” it could make better sense to stick with a relatively low fixed rate you know will never rise. But it’s ultimately your decision and one that nobody can make with certainty because we don’t know the future of mortgage rates. Also consider the costs of a refinance in the future and the fact that you’ll need to get approved for one (not always a slam dunk). Good luck!

  11. Louise February 13, 2016 at 5:00 pm -

    I am on track to retire in two years but just recently decided to save the extra mortgage payments instead of rushing to have a paid off mortgage. It would be the first time in my life I had any extra stash, but it will leave me paying a mortgage into retirement. A 5/1 ARM might save some interest now and lower the payment and give me 5 years to get it paid even in retirement. Is this a sound idea?

  12. Colin Robertson February 14, 2016 at 3:50 pm -

    Louise,

    A 5/1 ARM is a 30-year loan, it’s just fixed for the first five years. So it wouldn’t be paid in five years, but rather in 30 more years unless you paid it off early by making extra payments and/or a lump sum payment. Most financial experts advise against taking a mortgage into retirement, but it’s your decision.

  13. Adam February 16, 2016 at 11:17 am -

    Dear Colin,
    Im a first time buyer and 35 years old. I have friends telling me to aim for an FHA loan as the down payment is low. I want to buy a home that is about 100k and plan on paying it completely off within the 5 years. Would you say FHA loan or traditional 15 or 30 with 5/1 ARM? Which would benefit me more.

  14. Colin Robertson February 16, 2016 at 12:22 pm -

    Adam,

    If the home is only $100k the down payment required may not be much. And you can avoid mortgage insurance if you avoid FHA, which can save you a lot of money. FHA requires 3.5% down, some conventional options only 3%. Put down 20% and you avoid PMI.

    A 15-year loan will come with a lower interest rate and much less interest than a 30-year. The 5/1 ARM may be even cheaper, but you have to make extra payments to pay it off in five years. It’s still a 30-year loan so you have to pay extra to pay it off in five years. Do the math and determine what you put down, then narrow down your options by your goal of pay off.

  15. gary hill February 20, 2016 at 6:33 am -

    Colin,my partner & i are downsizing. We’ll walk away w/about 60 to 75 thousand after house is sold. He’s retiring in a year and i’m on disability. Looking to have a small mortgage($150000 or less) after down payment. Would like a monthly payment of $1300 or less(not including taxes,etc). The mortgage will be in his name-has credit score about 750. Was pre-approved w/Quicken for $180000. What’s our best option -5/1,10,15,etc. Really want to pay off quickly(partner’s 69 and i’m 60) Approximately,how much extra to pay off the 5/1 in 5 years. Say on a $130,000 loan at 4%. Thanks for any advice you can offer.

  16. Colin Robertson February 22, 2016 at 7:14 pm -

    Gary,

    A 5/1 ARM is still a 30-year loan, so you might be better off actually going with a short-term loan such as a 10-year fixed or 15-year fixed, etc. Of course you’ll need to make sure you still qualify with higher monthly payments on shorter-term loans. You have the option to do the 5/1 ARM, but you’d be subject to a rate adjustment after five years unless you paid it off (by making extra payments or a lump sum payment) before those five years are up.

  17. Tara April 9, 2016 at 11:38 pm -

    Hi Colin

    My husband and I are wanting to purchase our first home with a VA Loan. We are currently living in Hawaii (Oahu) and rent is very expensive so we want to put that money towards a home. We are only going to be here for another 2-3yrs at the most. Would the 5/1 ARM be our best choice since we plan to sell when we leave?
    We are very new at this so any advice would be really appreciated. Thankyou.

  18. Colin Robertson April 18, 2016 at 10:48 am -

    Tara,

    That can make sense but it can also backfire if for some reason you don’t or are unable to move as planned. Things don’t always work out as intended, but you can probably save some bucks with the 5/1 ARM. Gotta look at the pros and cons and potential pitfalls.

  19. RICARDO MOHAMED June 16, 2016 at 4:30 am -

    Hello i am a Veteran using my Certificate of Eligbility on a purchase of $412,500, i wanted to consider using a 5/1 Arm and have a much lower monthly, and then look at the possibilities of selling before the 5 year arm is up. What are your thoughts. Thank you. Also my loan officer is saying the current rate for 30 year fix is 3.66 for VA, is this the best and lowest 30 year fix rate for a Veteran purchasing a home today? and last but not least, explain the HARP program that President Obma has approved for home owners.

  20. Colin Robertson June 24, 2016 at 3:44 pm -

    Ricardo,

    It depends what happens – it could make a lot of sense and save you money if you actually sell before those five years are up, but it could backfire if things don’t go according to plan. Gotta see if the uncertainty is worth it…the savings that is. Hard to say if rate is good/bad without knowing all attributes of loan but in general 3.66% sounds pretty low. The HARP program is for existing underwater homeowners who owe more than their homes are worth.

  21. Harshil September 2, 2016 at 11:42 am -

    Hi I am first time buyer and thinking to get 5/1. What is a possibility to refinance the loan right after 5 years expire for another 5/1?

  22. Colin Robertson September 8, 2016 at 9:07 am -

    Harshil,

    It’s a common move and perfectly feasible as long as you qualify for the refinance as you would any other subsequent mortgage. You’d also want interest rates to be favorable at that time…

  23. Micki January 2, 2017 at 4:48 pm -

    Hi, I am on a fixed income and purchasing a home for 65,000 with 30,000 down. I’ve selected a 30 year fixed rate but am wondering if that’s the best option. It seems that I will be paying approximately $28,000 in interest by the time it’s payed off. I have to keep payments low and wondered if a 5/1 ARM would be better for me.
    Micki

  24. Colin Robertson January 3, 2017 at 9:46 am -

    Micki,

    The 5/1 could make sense if you think you can knock out that small balance fast, potentially before it resets higher to negate the savings of the ARM to begin with.

  25. Mark January 18, 2017 at 2:09 pm -

    Hello Colin

    I am possibly moving to the MA from Queensland, AUS.

    Our Mortgage products seem a bit different here and therefore I would like to ask just 1 question.

    On a $800,000 home with 40% down over 5 years fixed – I cannot find any lender who wants to take this, they only want 5/1 ARM or 10 year fixed minimum …. ?

    cheers Mark

  26. 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

  27. 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?

  28. 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.

  29. 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.

  30. 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.

  31. 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.

  32. 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.

  33. 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?

  34. 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.

  35. 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?

  36. 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.

  37. 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.

  38. 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.

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