30-Year Fixed vs. 5/1 ARM

June 24, 2011 18 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?

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.

After the first five years are up, the interest rate can adjust once annually, both up or down.

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?

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. That’s the tradeoff for that 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.

Example:

Loan amount: $350,000
30-year fixed payment: $1,773.40
5/1 ARM 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?

Well, there’s just one little problem.

It might not always be that way. In fact, it might only be that way 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 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.

[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 is probably a bad idea. 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? Check out the 30-year fixed vs. the 7-year ARM.

18 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.

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