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With a 5-year adjustable-rate mortgage, you'll get an introductory rate for the first five years you have the mortgage. These are sometimes referred to as "teaser" rates because they can be significantly lower than prevailing rates on fixed-rate mortgages. However, after that period's over, your interest rate will change every six months. Many homeowners will sell or refinance their homes before their adjustable-rate mortgage resets to avoid rate increases.
How does a 5-year adjustable-rate mortgage work?
A 5-year ARM is one type of hybrid mortgage since it has a period with a fixed interest rate (up to five years, in this case) followed by a period with an adjustable rate (up to 25 years, since 30 years is a typical loan term for ARMs as well as for fixed-rate mortgages).
ARM interest rates fluctuate based on economic conditions and market variables. With a 5-year ARM, you'll have a base interest rate called the margin. That never changes. The part that adjusts is called the index — the index is added to the margin and can go up or down. Lenders combine these static and moving parts to make the actual interest rate you pay on an adjustable-rate mortgage.
Though it's impossible to predict where the market will be in five years when your 5-year ARM starts adjusting, ARMs have some parameters that give you an idea of how much your rate could increase. These are usually presented as a set of three numbers (like 2/1/5) and tell you three things:
Initial cap. The first number indicates the highest your interest rate could shift the first time it adjusts. In the 2/1/5 example, it's a 2, so the first adjustment can't be more than two percentage points. Say you started with a 3.5% interest rate; your initial adjustment could increase your rate to 5.5%.
Subsequent cap. Also, sometimes called the periodic cap, this is how much the rate can change every time it adjusts. In the 2/1/5 example, the 1 means that when the rate adjusts every six months, it can't go up more than one percentage point. If your interest rate is at 5.5%, a 1% subsequent cap will not allow your rate to go beyond 6.5% for that period.
Lifetime cap. The third number shows you the absolute maximum that your interest rate could go up. In the 2/1/5 example, the lifetime cap would be a five percentage point increase. If your introductory rate was 3.5%, your highest possible rate would be 8.5%.
Compare caps as well as interest rates when you're looking at adjustable-rate mortgage lenders. Another point to note: It's not all increases. For example, your adjustable interest rate could go down in an environment with falling rates. However, your lender may set a floor, limiting how low your rate could drop.
» MORE: Compare 5- vs. 10-year ARMs
What are the disadvantages of a 5-year ARM?
On top of the whole after-five-years-your-rate-goes-up thing, there are other downsides to 5-year adjustable-rate mortgages.
Relatively short introductory period. A 5-year ARM doesn't let you luxuriate in a low-introductory rate the way an ARM with a longer fixed-rate period might. Before it starts adjusting, you'll need to decide on your next move (maybe literally, if you sell your home).
Greater uncertainty. Since the adjustable period of a 5-year ARM is five times as long as the fixed period (25 years, if you've got a 30-year loan), sticking with that mortgage brings considerable risk. You might feel confident that, given your career trajectory, you'll be able to make those larger payments. But if you're unsure how you'd handle a bigger mortgage payment, a 5-year ARM may not be your best option.
Costly to get out of. For a buyer who isn't planning to stay in a home very long, a 5-year ARM can be a great choice. But what if you're thinking about using a 5-year ARM to get into your dream home? It's crucial to recognize that if you need to refinance to afford the higher payments after five years, you'll have to deal with closing costs. Refinance closing costs can total 2% to 5% of the loan balance.
What are the advantages of a 5-year ARM?
In a falling rates environment, homeowners with ARMs can be in a good position — they don't have to refinance to get a lower interest rate. But even in rising rate climates, adjustable-rate mortgages have their pluses.
Goldilocks factor. Generally, with adjustable-rate mortgages, the shorter the fixed-rate period, the lower the interest rate. So a 3-year ARM will often give you the lowest rate — but that means you've got to deal with the rate adjusting after just three years. But a 5-year ARM will usually get you a lower teaser rate than a 7- or 10-year ARM while buying you a decent amount of time where you aren't stressing about interest rates. So for some home buyers, it's the "just right" ARM.
Potential to lower your lifetime interest. While you've got that low introductory rate, you could use some of the money you're saving to get aggressive with paying down your principal. Making additional payments against your principal lowers the amount you're borrowing and potentially allows you to pay less total interest over the life of the loan. But, again, a lot hinges on how the loan's adjustable period treats you.
More buying power. When home prices are on the rise, some buyers turn to ARMs as a way to stretch their home-buying budget. Since less of the monthly mortgage payment has to go toward interest — at least during that introductory period — buyers can often qualify for larger mortgages. It can be a helpful strategy, but it's vital to be sure you'll be able to swing a bigger payment down the line if you don't plan to move or refinance.