Best 5/1 ARM Loans of 2021 | U.S. News

Adjustable-rate mortgages are home loans with an interest rate that changes over time. This type of home loan can be risky, but with a lower initial interest rate than fixed-rate mortgages, adjustable-rate mortgages can be a good option if you plan to sell or refinance within a few years, before the lower interest rate adjusts.

The right home loan can deliver thousands of dollars in savings. This guide can help you understand adjustable-rate mortgages and find the right lender for your homebuying needs.

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An adjustable-rate mortgage is a home loan with an interest rate that changes over time. Unlike with a fixed-rate mortgage, which keeps the same interest rate for the life of the loan, your interest rate will change according to a benchmark rate.

The three most common types of ARMs are hybrid, interest-only and payment-option.

A hybrid ARM is the most common type of adjustable-rate mortgage. It has an initial interest rate that remains fixed for a certain amount of time and then adjusts periodically afterward. So a 5/1 adjustable-rate mortgage has one rate for the first five years and, after that, adjusts every year. A 3/1, 7/1 or 10/1 ARM works the same way, adjusting annually after the initial fixed-rate period (three, seven or 10 years, respectively).

An interest-only ARM is an adjustable-rate mortgage that only requires interest payments (no principal payments) during the initial payment period. During the initial payment period, the loan balance does not go down. At the end of the initial payment period, the loan is amortized based on the remaining term, and the required monthly mortgage payment increases substantially.

A payment-option ARM is an adjustable-rate mortgage in which the borrower can choose from multiple payment options. Usually, the options are:

If you make a payment that does not cover the interest, the unpaid interest is added to the loan balance and amortized. Payment-option ARMs are recalculated at predetermined intervals, such as every five years, or if the loan balance reaches a preset limit, such as 125% of the original loan balance. After recalculating the loan, the lender will set a required monthly payment to guarantee you will pay off the loan by the end of the remaining loan term.

With a convertible ARM feature, you can pay a conversion fee upfront so that the loan can be converted to a fixed-rate mortgage after a period of time. For this product, the initial interest rate may be a little higher than the rate on a nonconvertible ARM. The rate at conversion will be based on current mortgage rates and may be higher than the rate available for a new fixed-rate mortgage.

Adjustable-rate mortgages are available from home loan programs through the Federal Housing Administration, U.S. Department of Veterans Affairs and U.S. Department of Agriculture as well as for conventional and jumbo loans. Typical loan terms are 15- and 30-year, but 10- and 20-year terms are also common.

An adjustable-rate mortgage is like any other mortgage: A lender pays a seller for the home you want to buy, and you make regular monthly mortgage payments to the lender until the loan is paid off. The interest rate changes periodically, per the terms in the loan contract.

Most adjustable-rate mortgages start with a competitive initial fixed-rate period, often with a lower interest rate than what’s available on fixed-rate mortgages. When the period ends, the interest rate changes at predetermined intervals, according to the benchmark rate the loan follows.

An ARM interest rate can be based on a major index rate – such as the one-year Treasury constant maturity rate; the 11th District Cost of Funds Index, or COFI; or the London Interbank Offered Rate, or Libor – or it may be the lender’s own cost of funds index. The lender chooses its own index. The lender adds a margin to the benchmark rate to calculate your interest rate.

Your interest rate changes when your adjustment period ends. The lender can raise your rate if its fully indexed rate is higher than your current mortgage rate. If the benchmark rate goes down, the lender might lower its fully indexed rate and, accordingly, your rate.

Caps set the boundaries on how much your interest rate can change. An interest rate cap can be periodic, limiting how much the rate can rise at each readjustment period, or lifetime, restricting your interest rate for the life of the loan. Nearly all adjustable-rate mortgages are required to have a lifetime cap.

For example, if your initial rate is 4% with a 2% periodic rate cap and the fully indexed rate is 7% at the time of your recast, your rate will only rise to 6%.

Payment caps limit the amount your monthly payment can increase, regardless of how much the benchmark rate increases. While it keeps your monthly payment amount in check, it doesn’t stop interest from building. Any unpaid interest will be added to your outstanding loan balance.

An adjustable-rate mortgage can be a good choice when it offers a competitively low interest rate and you can avoid or minimize the impact of a potentially rising rate in the future.

“A major question is the borrower’s time horizon,” says Jack Guttentag, author of The Mortgage Professor blog. If you plan to sell the property or refinance before the first adjustment period or before future interest charges outweigh early interest savings, you could save money.

“Another circumstance in which an ARM might be preferable, even when the time horizon is indefinite,” says Guttentag, “would be where the monthly payment difference is very important now, but in the future the borrower expects her income to increase significantly.”

An ARM can be a good option for first-time homebuyers who plan to refinance or sell their home or expect an income boost in a few years. For example, a military family on limited deployment or a medical student who will become a doctor might be a candidate for an ARM.

However, an ARM is not the best choice for every borrower because of the potential for rate increases over time. ARMs can be complex, so borrowers should fully understand their benefits and drawbacks before moving forward.

“Taking an ARM now with the goal of refinancing at the end of the first adjustment period can be complicated,” says Matthew Ribe, senior director of legislative affairs and corporate secretary for the National Foundation for Credit Counseling.

The financial advantages of an ARM are generally realized during the earlier years of the loan, so an ARM is not a good choice for a borrower who intends to own the property beyond that early period and who does not plan to (or can’t) refinance to a lower-cost loan.

ARM terms can be difficult to understand. You may be surprised at how much the payment can increase in the future or at the challenges you could face in selling or refinancing the property.

One selling point of ARMs is that, technically, the rate could go down. But because an ARM tends to start low, increases are typically inevitable, especially for loans that originate in an already-low-interest market. In some loans, the rate is not allowed to drop below a predetermined minimum, even if the benchmark rate goes lower.

There are several ways to achieve negative amortization on an ARM, resulting in a loan balance larger than what you originally borrowed.

Before considering an ARM, keep in mind that you can’t get something for nothing. Banks make ARM loans because they believe loan rates will rise enough to offset your savings in those initial years. The unpredictability of an ARM makes it inherently riskier than fixed-rate mortgages, and that risk is your trade-off for favorable starting terms.

Your home loan’s interest rate influences your monthly payment and how much the loan costs over time. The lower your interest rate, the lower your monthly mortgage payment and overall cost of borrowing, so it pays to shop around for the lowest mortgage rate you can get.

Many factors influence mortgage interest rates, including benchmark rates, borrower demand and your credit score. Take these steps to get the lowest mortgage rate possible:

Advertised rates are best-case scenarios, offered to borrowers with the strongest applications. Your credit score, size of down payment and debt-to-income ratio (how much of your gross income goes to debt payments) have a major influence on the loan rates you’re offered. Before you start rate shopping, check your credit history for errors and identify areas to improve.

Loan rates vary based on loan type and terms. For example, the interest rate for a 30-year fixed-rate mortgage isn’t likely to be the same as a 30-year ARM. Compare mortgage rates for different programs to see which offers the best rate, as these can fluctuate depending on demand.

With the current low-interest-rate environment, there’s heavy demand for 30-year fixed-rate mortgages as consumers lock in low long-term rates. “There’s a lower demand for adjustable rates, so in turn, the rates are higher,” says Rob Sickler, loan originator with Mortgage Network Solutions.

Compare mortgage rates with a few lenders so you can select the one that offers the lowest mortgage rate. You can do this by prequalifying, which requires a soft credit pull that doesn’t affect your credit score.

As you research loan options, you may find that a loan with a low interest rate can keep you under the debt-to-income ratio limit set by the lender.

“The lender uses this initial interest rate to decide whether you have enough income to qualify for the mortgage, even though the rate usually rises at the end of the initial adjustment period,” says Guttentag. That could translate to an unaffordable monthly mortgage payment if your income does not rise.

The four key factors for choosing the best adjustable-rate mortgage lender are:

Product offerings. The best lender will offer products with the terms and features that meet your needs, whether that be conventional, FHA or VA loans.

Interest rates. A low interest rate can save you tens of thousands of dollars over the life of your loan. Even a fraction of a percent can drive significant savings – or costs. Compare mortgage rates from multiple lenders to find the best deal.

You might want to discuss the pros and cons of various ARM options with the lender, including:

Closing costs. Lenders have some flexibility when it comes to many closing costs. For example, some, but not all, charge an origination fee. Generally, lower upfront costs are associated with higher interest rates. If you are looking for a loan with as little out-of-pocket cost as possible, you may face higher costs overall, and vice versa.

Customer service. As with any major purchase, find out what other customers say. You may be tied to this lender for years or decades, so choose one that has demonstrated an ability to provide good customer service.