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Term And Benefits Of 5 Year Adjustable Rate Mortgage

Posted by Zulkarnai Harun Ar Rashid |

A 5 year ARM, also known as a 5/1 ARM, is one option being offered today by many mortgage companies. This particular loan has a fixed rate for the first five years and then changes once each year for the remaining life of the loan. 

The benefit of a 5/1 arm is that it gives the borrower a much lower interest rate and payment initially. For example, as of today March 16, 2011, a 5/1 arm with many mortgage lenders has an interest rate of 2.75% compared to a 30 year fixed with an interest rate of 4.625%. For a loan of RM250,000 the monthly payment on the 5/1 arm would be RM265 less. For borrowers who are confident they will sell their home within that 5 year period, this kind of loan would be an ideal product. However, borrowers that are just looking to lower their payments may find this loan disastrous because after the 60th month the 5/1 arm can adjust by up to 5 percentage points! This is referred to as the 1st adjustment cap. Every 12 months after the initial adjustment, the loan will adjust again which is referred to as the periodic adjustment.

Typically, the cap on this adjustment is less than the first adjustment cap. Many lenders set this at a maximum of 2 percentage points. The final term for the 5/1 arm is the lifetime adjustment cap. This is the amount that the interest rate can rise during the entire term of the mortgage, which is typically 30 years. Many times, this is equal to the initial adjustment cap, or 5 years. In other words, a 5/1 arm typically has the terms 5/2/5 (initial cap = 5%; periodic cap = 2%; lifetime cap = 5%). For example, a 5/1 arm that closes with an interest rate of 2.75% will remain fixed for the first 5 years. At the end of 5 years it can rise to a maximum of 7.75% but at no time during the term of the loan can it rise higher than 7.75%. If the interest rate rises to 5.00% after the initial adjustment, then in 12 months it can rise as high as 7.00% (2 percentage points). 

The change in interest rate is tied to an index that determines how much your interest rate will rise or fall at each adjustment period. The most common indices used are the U.S. Treasury Bill and the London Interbank Offered Rate (LIBOR). Both are posted daily on the Wall Street Journal as well as most other financial publications. Every lender sets a "margin", which is the spread between the index and the interest rate offered on the loan. For example, as of March 16, 2011, the 1 Year LIBOR was equal to 0.772%. Many lenders will have a margin of approximately 2 percentage points. Therefore, the interest rate offered on the 5/1 arm would be equal to 2.75%. In 5 years, if LIBOR was up to 1.500%, then the 1st adjustment on the loan would take the rate up to 3.50%. Of course, interest rates always have the potential of falling also. 

It is absolutely critical that borrowers thoroughly discuss all details and options with a mortgage professional and trusted financial advisor before closing on an adjustable rate product. Even though a 5/1 arm can make sense for people who will be selling their home within 5 years, it can be devastating for those just trying to lower their monthly payment but not having any intention of moving within 5 years. Borrowers should always remember to protect themselves against the downside and prepare for the worst case scenario.

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