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. It has a fixed-rate period (up to five years, in this case) followed by an adjustable-rate period (up to 25 years, since most ARMs and fixed-rate mortgages have 30-year terms).
ARM interest rates change with the market. The margin is a set number your lender assigns when you apply, and it never changes. The index is a benchmark rate that moves up and down with the market. Your lender adds them together to get the rate you pay.
It's impossible to predict where the market will be in five years when your 5-year ARM starts adjusting. But ARMs have 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
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 when rates are falling. However, your lender may set a floor, limiting how low your rate could drop.
🤓Nerdy Tip
You're not wrong if you could swear there used to be 5/1 ARMs. However, in 2020 and 2021, lenders began using a different benchmark interest rate to determine adjustable mortgage rates. Because the new index rate, Secured Overnight Financing Rate, or SOFR, reflects more frequent market changes, ARMs adjust every six months once their introductory period ends. As a result, lenders nowadays more commonly offer 5/6 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. The adjustable period of a 5-year ARM is five times as long as the fixed period. If you have a 30-year loan, that’s 25 years. 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. A 5-year ARM can be an appealing way to afford your dream home. Just remember that refinancing after the introductory rate ends also means paying closing costs. Refinance closing costs can total 2% to 5% of the loan balance.
What are the advantages of a 5-year ARM?
When rates fall, ARM holders benefit without refinancing. But ARMs have advantages even when rates rise.
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 homebuying budget. During the introductory period, less of your payment goes toward interest, so you may qualify for a larger mortgage. It can be a helpful strategy, but it's vital to be sure you'll be able to afford a higher payment later if you don't plan to move or refinance.
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