When mortgage rates are rising, it may seem crazy to consider a 5/1 ARM (adjustable-rate mortgage) or a 15-year fixed-rate loan. After all, shouldn’t you lock in the lowest possible rate for the longest possible term?
For some borrowers, though, an ARM or a shorter-term loan could be the best way to get a lower mortgage rate now.
Mortgage Rates Are Rising
While we’ve gotten used to better-than-great rates in recent years, the low-rates party stopped on Election Day. According to Freddie Mac, mortgage rates climbed for the final nine weeks of 2016. The year ended with an average of 4.32 percent for a 30-year fixed-rate loan, 3.55 percent for a 15-year loan, and 3.30 percent for a 5-year hybrid ARM.
While those rates represent a two-year high, they are still well below the highest mortgage rate of 18.45 percent in October 1981 and even below the annual average of 5.87 percent in 2005 at the height of the real estate buying frenzy.
Low Rate Vs High Rate Economy
Still, borrowers in 2020 need to take a new look at their mortgage loan options and consider which loan works best for their refinance or purchase. In a low-rate environment, more borrowers chose fixed-rate loans. Many took advantage of low 15-year refinance rates to shorten their loan terms.
ARMs comprised just 6.5 percent of all loan applications during the week ending December 16, 2016, according to the Mortgage Bankers Association’s Weekly Mortgage Applications Survey, which was the highest level since February 2016.
Before the housing crisis, there were some pretty creative ARMs out there. You could find loans with rates that changed every month, loans that allowed borrower balances to increase over time, and loans that determined the borrower’s ability to repay based on rates as low as one percent.
Today’s ARMs are much safer. These loans begin as fixed mortgages for a period lasting three to ten years, and then they convert to adjustable loans for the remaining mortgage term. “Hybrid” loan products begin resetting once the introductory period expires, but rate increases are controlled by caps.
What is a 5/1 ARM? What Does The “5” and “1” Mean?
For instance, a 5/1 ARM has a fixed rate for five years, and then its rate would reset once a year for the remaining 25 years of its term. The “5” in the loan’s name means it’s fixed for five years, and the “1” means it can reset every year after that, within restrictions called “floors” and “caps.”
The starting rate for a 5/1 ARM is generally about one percent lower than similar 30-year fixed rates. Its interest rate adjustments depend on several factors:
- Index (a published financial indicator)
- Margin (an amount added to the index to cover the lender’s costs and its profit)
- Caps on the amount a rate can rise or drop at a single adjustment
- Floors, which limit how low the rate can go
- Lifetime limits (which keep the interest rate from exceeding a certain level)
How ARMs Adjust
One common 5/1 ARM is based on an index called the 1-Year LIBOR. As of this writing, that index is 1.69 percent. If you had a 5/1 ARM with a 2.75 percent margin (this is fairly typical), and it was adjusting today, your new rate would be 4.44 percent.
But there’s more to it than that. There are rules that restrict how much your rate can adjust. Imagine that your starting rate was 2.25 percent, and that was fixed for five years. Now, your 5/1 is adjusting for the first time.
Suppose its terms are 2/2/5, which means that your interest rate can increase no more than two percent at the first adjustment, no more than two percent for each future adjustment, and can never go higher than five percent over your start rate.
Your rate started at 2.25 percent, which means right now, it can’t go higher than 4.25 percent, even if the index plus margin is 4.44 percent. Over your loan’s lifetime, its rate can never exceed 7.25 percent.
Is A 5/1 ARM A Good Idea?
A 5/1 ARM can work out in your favor under the right conditions. Here’s when a 5/1 ARM might be a good idea.
The advantage of a 5/1 ARM is that during the first phase, you get a much lower interest rate and payment. If you plan to sell in less than six or seven years, a 5/1 ARM could be a smart choice. In a five year period, that savings could be enough to buy a new car or cover a year’s college tuition.
Keep in mind that the National Association of Realtors (NAR) pegs the average time owners keep their properties at about seven years. Younger buyers sell sooner, and older ones tend to stay longer.
The primary disadvantage of an ARM is the risk of interest rate hikes. For example, it’s possible that the 5/1 ARM with a 2.25 percent start rate could (worst case) increase as follows:
- Beginning of Year Six: 4.25 percent
- Starting Year Seven: 6.25 percent
- Remaining Years 8 through 30: 7.25 percent
This doesn’t mean your ARM will increase; it means that it’s possible. TradingEconomics.com, for instance, forecasts that in 2020, the one-year LIBOR will hit 2.5 percent. If you have a loan adjusting at that time, and it has a 2.75 percent margin, you could end up at 5.25 percent — unless you have caps that will keep your rate lower.
The 15-Year Fixed Loan
There’s another way to secure a rock-bottom interest rate if you can afford higher payments. The 15-year fixed mortgage generally carries an interest rate that’s similar to that of the 5/1 ARM. And unlike the ARM, the interest rate is fixed for the entire term of the home loan.
The catch? You get half as much time to clear your loan balance, so your monthly payments are higher. But while your loan gets retired in half the time, your payment is NOT twice as high. Not even close.
Currently, Freddie Mac’s average rates are as follows:
- 30-Year Fixed: 4.2 percent
- 15-Year Fixed: 3.44
The lower interest rate keeps your 15-year payment less than twice your 30-year payment. In fact, at today’s average Freddie Mac rates, the 15-year payment is just $2,120, less than 1.5 times the 30-year payment of $1,467.
Clearly, the disadvantage of a 15-year loan is that it can be more difficult to afford the higher payment.
Fixed Versus ARM
If you plan to keep your home (and your mortgage) for just a few years, the 5/1 ARM may be a smarter choice. Its interest rate can be slightly lower than that of the 15-year loan. Plus, you have the option of making a higher payment when you want to and can afford it, but you’re not locked into an obligation that might be un-affordable.
If you plan to keep your home for a long time, and can comfortably afford the higher payment, the 15-year loan could be the better option.
Before committing to a higher loan payment, however, examine your finances and make sure you’ve done these things first:
- Paid off any higher-interest debt
- Maxed out your 401(k) if your employer offers matching contributions
- Saved an emergency fund of two-to-six months’ expenses
As always, it’s essential to compare loan terms and rates based on your individual circumstances and long-term financial plans.
What Are Today’s 5/1 And 15 Year Mortgage Rates?
Rates for 5/1 ARMs and 15-year fixed loans often track each other fairly closely. Be sure and get quotes for both programs when you contact competing lenders for mortgage quotes.