There’s a popular new loan in town that a lot of credit unions seem to be offering known as the “5/5 ARM,” which essentially replaces the more aggressive 5/1 ARM that continues to be the mainstay at larger banks and lenders.
The San Francisco Federal Credit Union offers it via their POPPYLOAN, Caliber Home Loans has it, and PenFed also includes the product in its stable of loan programs.
How the 5/5 ARM Works
- It’s an adjustable-rate mortgage with a 30-year term
- That has a fixed interest rate for the first 60 months
- It then adjusts in year six and every five years thereafter
- With adjustments in year 6, 11, 16, 21, and 26
First off, you should know that the 5/5 ARM is an adjustable-rate mortgage. However, you get a fixed rate for the first five years of the loan term, just like a 30-year fixed.
After that five years, the mortgage experiences its first rate adjustment, either up or down, based on the combination of the margin and the underlying mortgage index.
The initial rate cap tends to be 2% on this program, meaning the rate can’t rise more than two percentage points from its starting rate, or fall by more than that in year six.
Let’s look at an example of a 5/5 ARM to illustrate:
Starting rate: 3.125%
Index: 1-year LIBOR
First adjustment: Year 6
Initial cap: 2%
Periodic cap: 2%
Lifetime cap: 5%
If the starting rate is 3.125%, the rate could rise to 5.125% at the beginning of year six, or it could potentially fall.
However, there will likely be a floor that limits downside movement, which is generally the margin. This margin will probably be somewhere in the 2% range, so the fully-indexed rate can never go below that, even if the associated LIBOR index drops to 1% or lower.
In other words, your rate probably won’t move lower than the initial start rate, so it’s best to focus on how high the rate can go.
Over the life of the loan, the highest it could go would be 8.125%, based on that lifetime cap, though it would take a few adjustments to get there thanks to the 2% periodic cap.
Pros of the 5/5 ARM
- You get a fixed rate for the first five years
- During which time you might sell your home or refinance your home loan
- And there’s only one rate adjustment in the first 10 years
- Which could limit the damage if mortgage indexes remain reasonably low during that time
The obvious advantage to the 5/5 ARM versus the 5/1 ARM is the fact that the mortgage only adjusts every five years, as opposed to every year after the first five years are up.
With the latter, you still get an initial five-year fixed period, but then the rate is subject to annual adjustments, which can be pretty scary and potentially dangerous in a rising rate environment.
The 5/5 ARM, on the other hand, will only see a total of five rate adjustments throughout the life of the loan, which seems a lot more manageable, and only one during the first decade of the loan.
These will take place at the start of year 6, year 11, year 16, year 21, and year 26. That gives you a lot more certainty than the annual-adjusting mortgage.
However, it doesn’t mean the 5/5 ARM is necessarily a better product. In fact, it could wind up costing you if things don’t go your way.
Downsides of the 5/5 ARM
- The interest rate isn’t fixed beyond the first five years
- The 5/5 ARM will likely adjust quite a bit higher in year six
- And then the rate will be stuck there for another five years
- Resulting in significantly higher monthly mortgage payments for a full 60 months until the next adjustment
For one, the initial interest rate on the 5/5 ARM might be higher than that of the 5/1 ARM, though I’ve seen the two priced similarly.
In other words, you might be able to get a rate in the 2% range versus a rate in the low 3% range on the 5/5 ARM. So you’re saving money from the get-go with the 5/1 ARM.
This is basically because mortgage lenders can sell the 5/5 as a safer product, even though it might not be depending on the adjustments.
Additionally, you may never actually face a rate reset if you sell or refinance before the initial five-year period ends, meaning the 5/5 ARM wouldn’t provide any benefit, and worse, would simply be more expensive for the first 60 months.
Secondly, the caps may be higher on the 5/5 ARM compared to the 5/1 ARM. For example, the initial rate cap might only be 1% on the 5/1 ARM, meaning if it starts at 2.5%, it can’t go any higher than 3.5% after the first reset.
Whereas the 5/5 ARM might have an initial cap of 2%, pushing an initial rate of 3.125% to as high as 5.125%. The other obvious downside is that you could then be stuck with that higher rate for another five years before another rate adjustment came along.
With the 5/1 ARM, any rate improvement would be realized within a year, when the annual adjustment is due.
Of course, if the associated index was simply rising over time, it could mean a 1% higher mortgage rate year after year, pushing that 2.5% rate to 5.5% after three years, and even higher after that.
Again, there’s always the opportunity to refinance your ARM (assuming you qualify for a mortgage at that time and rates are favorable), so it might be moot what happens after the initial fixed period.
But the 5/5 ARM does at least provide for a little more rate security in that adjustments only come every five years, giving the homeowner time to make a decision. This is probably why they’re being touted mainly by credit unions, which tend to offer more conservative lending products.
When comparing the loan programs, be sure to pay special attention to the caps (especially the initial cap), the index being used once the rate becomes adjustable, the margin, and the adjustment rules.
And as noted, compare the interest rates on both products side by side to ensure you aren’t paying extra for something you won’t even need or benefit from. My guess is many homeowners with ARMs don’t keep them past the first adjustment anyway.