Table of contents
- What is a 5/6 ARM?
- Adjustable rate loans: A general synopsis
- The 5/6 ARM: A deeper dive
- What is a 5/1 ARM?
- 5-year ARM rates vs. 7-year ARM rates
- 5-year ARM rates vs. 10-year ARM rates
- 5-year ARM rates vs. 30-year fixed mortgage rates
- 5-year ARM rates vs. 15-year fixed mortgage rates
- When a 5-year ARM makes sense
- When a fixed rate mortgage makes sense
- The math on a 5/6 ARM loan
- How to find the best 5-year mortgage rates
When taking a look at mortgage rates during your homebuying process, you’ll notice that ARMs (adjustable rate mortgages) are almost always presented as fractions: 10/1, 10/6, 7/1, 7/6, and so on. Same goes for the 5-year ARM. Specifically, a 5/6 ARM is an adjustable rate mortgage that has a fixed rate for the first five years (hence the “5”) and then transitions to an adjustable rate for the remainder of the loan. The “6” denotes a rate “reset” every six months or biannually. This doesn’t necessarily mean you will pay more in interest; it just means that information from the relevant indices + margin will be applied to your loan every six months, and depending on the interest rate environment, your payments may increase, decrease or stay the same.
It’s important to note that the concept of rates readjusting every six months is new in the marketplace. For decades, 5-year ARMs have reset on an annual basis during the adjustable rate period; hence the popular 5/1 ARM. However, as explained below in greater detail, the majority of lenders are moving to an adjustable rate mortgage that resets every six months in order to capture more accurate market information. Welcome to the era of the 5/6 ARM.
An adjustable rate mortgage, or ARM, is a type of mortgage with two distinct rate periods—one fixed and one adjustable. In that sense, it’s really a hybrid. An initial fixed rate period (typically 5, 7 or 10 years) is followed by a longer period where the rate adjusts according to the loan agreement. Accordingly, a 5-, 7- or 10-year ARM is not to be confused with a 5-, 7-, or 10-year mortgage; the initial digits only refer to the number of years the rate remains fixed before transitioning to the adjustable rate period.
The adjustable rate is based on an index that reflects market conditions plus the marginal rate, which is a percentage predetermined by your lender and outlined in your mortgage agreement. The margin never changes but the indexed rate does. Together, these create the fully indexed interest rate that defines the ARM.
While borrowers can expect attractive, even below-market rates during the initial fixed period, the adjustable rate period is heavily influenced by current market conditions—namely Treasury transactions in the securities repurchase market. Rates that adjust downward could provide you with ample savings while conditions that result in a higher rate could force you to pay thousands of dollars more over the life of the loan. It all depends.
Now that you’re familiar with adjustable rates and have had an introduction to 5/6 ARM rates, let’s go a little deeper into how these interest rates are determined.
As we said above, the initial fixed rate period is offered to borrowers at a below market rate, thus providing a period of savings and predictability that homeowners enjoy. This is especially true for first-time homebuyers who take advantage of these low rates to make purchases possible.
Today’s lenders typically offer 5-, 7- or 10-year ARMs. While that’s plenty of time to build equity, raise income levels and even determine if a refinance is right for you, it leaves a lot of time on the back end of the loan. For a 5-year ARM that’s offered as part of a 30-year mortgage, borrowers could potentially experience up to 25 years on the back end of the loan; in other words, 25 years of adjustable rates that you have little control over.
While there’s always the possibility of paying more once the adjustable rate period kicks in, the good news is that even in the event of a rate hike, you won’t be on the hook for an exponential rise in monthly payments. The mortgage industry protects borrowers from severe rate increases by offering interest rate caps.
A cap is essentially a limit placed upon the ARM so it cannot rise to a level that would be unreasonable. Today’s lenders offer a couple different types of rate caps. Let’s explore.
Initial interest rate cap
For homeowners who have a 5/6 ARM, the monthly payment that’s bound to startle them the most is the first mortgage payment directly following the 5-year fixed rate period. This is the initial adjustment rate period and most lenders set a cap of 2%, meaning the combined margin + index rate cannot jump more than 2% above what you were paying during the fixed rate period.
Periodic interest rate cap
The second kind of interest rate cap for a 5-year ARM is the periodic or incremental interest rate cap. As you cycle from one six-month adjustment period to the next, your lender sets a cap on how much the mortgage rate can increase—this, too, is frequently set at 2%.
Lifetime cap on interest rate
Mercifully, there also exists a lifetime cap on interest rate increases over the life of the loan. While this rate can change from lender to lender, it’s typical for this to be set at 5%. And while the idea of experiencing only a 5% increase can’t be very comforting to most individuals with a 5-year ARM, the good news is that rates haven’t had a 5-point swing in nearly two decades. The odds are extremely slim that you’ll ever have to climb the ladder 5% when it comes to monthly mortgage payments. However, if it were to come to that, caps are here to provide a safety net.
Lenders often disclose these caps in shorthand percentages, such as in the following example:
- 2% = The percent cap applied to your initial adjustment rate period
- 2% = The periodic or subsequent percent cap applied to additional interest rate periods
- 5% = The maximum lifetime rate increase your loan agreement allows**
Just as there are ceilings or caps, there also exist floors. Long before the current era of plummeting interest rates, lenders protected themselves by establishing floors for adjustable rate mortgages, thus guaranteeing a minimum interest income in the event of dramatically falling interest rates. There are lifetime floors as well as floors that are applicable from one rate period to the next. Check with your lendr to see if floors apply to your ARM.
Now that we know a little about the 5/6 ARM and how ARMs operate in general, let’s take a look at the widely recognized 5/1 ARM loan—an adjustable rate mortgage familiar to many.
As you can see, the 5/1 ARM consists of five initial years at a (low) fixed rate followed by a second period (the “1”) where the rate readjust annually based on the prevailing interest rate + margin. So it’s very similar to the 5/6 ARM; the rate readjustment period is the main difference.
However, as a result of some changes in the greater financial sector, the popular 5/1 ARM is being phased out. It’s a process that began over the last year and will continue until the 5/1 ARM is no longer in use by most lenders.* The reason has nothing to do with the adjustment rate period itself but everything to do with financial indices that inform the rates.
LIBOR is in, SOFR is out
What’s LIBOR? And what’s SOFR? We mentioned financial indices up above. Well, LIBOR (short for the London Interbank Offered Rate) has for decades been the go-to index for providing variable interest rates to banks, credit card companies and other lenders. In recent years, however, regulators have uncovered some flaws in the index that left it vulnerable to corruption and decreasing accuracy. Given these challenges, Fannie Mae and Freddie Mac have said that they will no longer approve LIBOR-based ARMs.
Fortunately, there is another financial benchmark that has proven to be accurate and reliable, and unlike LIBOR, its rates reset every six months as opposed to once a year. Called the Secured Overnight Financing Rate (SOFR), it’s an index formulated to resist manipulation, and it uses data based on large-volume transactions in the Treasury market to determine prevailing interest rates. For accuracy purposes, it also resets every six months as opposed to once a year.
Since SOFR incorporates secure financial transactions already collateralized, its data offers a more precise portrait of market conditions, and therefore a more accurate interest rate for your ARM (when added to your lender’s margin).
Whether it’s a 5/1 ARM or a 5/6 ARM it’s worth looking to see how it compares to another popular ARM issued by lenders: the 7-year ARM.
Admittedly, the 5-year ARM and its 7-year counterpart have much in common:
- They both have a short initial fixed rate period
- They both have long adjustable rate periods
Here are the key differences:
- A 5-year ARM typically boasts a more attractive interest rate during the initial fixed rate period. This is an attempt to balance out the longer period of risk associated with the ARM on the back end.
- A lower interest rate for the first five years also serves as an incentive for first-time homebuyers to take the plunge of homeownership. With a low rate, they can more easily manage future payments. As for the potential risk of higher payments within the ARM period, many will simply refinance into a fixed rate as their initial rate period ends or decide to sell their house and relieve themselves of the mortgage.
Let’s compare the 5-year ARM to the 10-year ARM.
While both are adjustable rate mortgages, it should be quite apparent that one is twice as long as the other. This produces a few crucial differences worth examining:
- Lower interest rates: Again, the 5-year ARM will have the lowest interest rate out of all the ARMs, and it may be markedly lower than the 10-year ARM.
- Homebuyer incentive: Low interest rates for a 5-year ARM as compared to a 10-year ARM mean that there is a distinct incentive for homebuyers concerned with immediate affordability to choose this loan. While they may have reservations about the back end of the loan, the attractive up-front interest rate offered in a 5-year ARM may prove to be a decisive factor in achieving homeownership.
- More house: With a lower interest rate resulting in lower monthly payments (for the first five years) the 5/6 ARM has an advantage over the 10/6 ARM: it may allow you to buy “more house” and secure a mortgage on the home of your dreams, not just the home you can afford.
- Sell soon: Some homebuyers have no intention of living more than five years in the home. If that’s the case, a 5-year ARM might be the ideal mortgage product to consider, with more attractive rates than the 10-year ARM.
While there are ample reasons many borrowers seek out the 5-year ARM, the 10-year ARM certainly has its merits, especially on the back end of the loan. For example, more time in the back end (for a 30-year mortgage it would be 25 years; for a 15-year mortgage it would mean 10 years) creates additional risk for a prolonged rate increase. If you’re at all wary about your ARM adjusting upwards, a 5-year ARM provides an expansive territory for such concerns. A 10-year ARM somewhat mitigates that. Of course, refinancing into a fixed rate mortgage could potentially solve this problem altogether.
One of the most important decisions you’ll need to make as you prepare to get your mortgage or refinance your home is whether to pursue an adjustable rate or a fixed rate. Let’s look at some of the pros and cons of a 5-year ARM vs. a 30-year fixed rate.
Advantages of securing a 5-year ARM
- The 5-year ARM will provide borrowers with a lower interest rate during the initial period. If you’re looking for front-loaded savings, the 5/6 ARM is superior to the 30-year fixed rate mortgage.
- The low interest rate not only results in reduced monthly payments, but it can help you afford your home to begin with by leaving more money available for the down payment and even avoiding private mortgage insurance (PMI).
- The 5-year ARM is ideal if you plan to sell your home after five years. Think about it: You were able to afford your home, lock in savings and now just as the initial fixed rate is set to expire, you’re selling your home and avoiding the unpredictability of variable rates. A 30-year fixed rate mortgage offers no such advantage. While opportunities to refinance will always be available, the interest rate you pay on your existing mortgage remains the same throughout the life of the loan.
Disadvantages of securing a 5-year ARM
- While a 5-year ARM can deliver savings during the initial fixed rate period, once it transitions to the adjustable rate period, all bets are off. If your tolerance for unpredictability is not terribly high, you’d be better off with a fixed-rate mortgage. Many borrowers find comfort in paying off their purchase in steady increments without dealing with fluctuating market conditions.
- In a low-interest-rate environment, the difference between an ARM and a 30-year fixed rate may not be terribly wide. A 5-year ARM may be lower—but not by much. In such circumstances, a 30-year fixed rate can provide two things: savings and peace of mind over a considerable time span.
The 15-year fixed rate mortgage remains a popular choice for those willing to absorb higher monthly payments for a chance to more quickly pay off their debt. Let’s see how it compares to a 5-year ARM:
Both the 15-year fixed rate mortgage and the 5-year ARM offer borrowers an opportunity to receive lower-than-average interest rates. However, frequently the 15-year fixed rate is lower than available rates for a 5/1 or 5/6 ARM. In addition, with a 15-year mortgage, you are on an amortization schedule designed to pay off your entire loan + interest in 15 years. That means higher monthly payments no matter how low the interest rate. For individuals with a solid income and proven creditworthiness, a condensed payment schedule might be preferable. It’s always wise to run through the various scenarios on a mortgage calculator to see if you are comfortable with the estimated payments.
Additionally, much like the 30-year fixed rate, the 15-year fixed rate mortgage provides the borrower with predictability. In a world of variable rates and changing costs, this can be a highly sought after commodity. Unfortunately, a 5-year ARM does not offer predictability. The mortgage rate during the adjustable period of the loan, while tempered by margins, could still fluctuate upwards and cost you hundreds of extra dollars per year in payments. It could also result in hundreds of dollars per year in savings—or more. With an ARM, the potential to leverage variability for savings is an acceptable built-in risk. But this is true for select individuals only.
In a sense all ARMs are hybrid loans, meaning each distinct one is designed with elements of both a fixed rate and an adjustable rate. That said, people choose ARMs—particularly a 5-year ARM—because of the introductory low rate that often generates enough up-front savings to make up for whatever comes next. And these days, most homeowners transition out of an ARM in advance of confronting its full effects. They either sell or refinance.
Many are first-time homebuyers who are getting their finances together and preparing for a bigger purchase later on; these homeowners typically exit the ARM by selling after five years of superior interest rates. Some intend to refinance and transition to a fixed rate. Whatever the exact context may be, if frontloaded savings are a priority, why not choose the ARM with the best introductory interest rate? This is the allure of the 5-year ARM.
Fixed rate mortgages remain the cornerstone of the American homebuying experience and they aren’t going anywhere. In recent years, a low-interest rate environment has only further underscored their importance to homeowners. While an ARM is a gamble, a fixed rate mortgage is steady and predictable, and if spread out over 30 years, it can be quite affordable. And with the increasing popularity of refis, homeowners are realizing that even if they’ve secured a suboptimal interest rate, there will likely be an opportunity to sit down with a lender and talk about refinancing into a new agreement and potentially lower your interest payments. A home is an investment, and a fixed rate mortgage is a great way to make it affordable and easy to understand.
It can be beneficial to look at a 5/6 ARM with the help of an example. Below, we compare a 5/6 ARM (as part of a 30-years mortgage) with a straight up conventional 30-year fixed mortgage.
Buyer X and Buyer Y both have been vetted and approved for 30-year mortgages. Buyer X decides to go with a 5-year ARM, thus locking in the lower introductory rate of 2.5%. Buyer Y opts for the safer, more predictable 30-year fixed rate at the still very reasonable 3% mortgage rate.
Buyer X: First 5 years of a 5/6 ARM at 2.5%
- Purchase price: $400,000
- Loan amount: $320,000 (assumes 20% down payment)
- 5-year ARM monthly payment: $1,264
- Total paid after 5 years: $75,840
Buyer Y: First 5 years of a 30-year fixed mortgage at 3%
- Purchase price: $400,000
- Loan amount: $320,000 (assumes 20% down payment)
- 30-year fixed rate monthly payment: $1,349
- Total paid after 5 years: $80,940**
After 5 years, Buyer X’s decision to get an ARM featuring a lower introductory interest rate resulted in a savings of $5,100.
In today’s lending environment, borrowers are presented with many products and choices when it comes to getting a mortgage. While a fixed rate mortgage is still the most popular option for most individuals, those who are more risk-tolerant may enjoy the benefits of obtaining a 5-year ARM.
It’s always important to understand your financial strengths and weaknesses, how much you can afford and what your short-and long-term homeownership goals are. Once you have that sorted, talk to a trusted lender who can guide you through the process and help you find the best 5-year mortgage rates available today.
- *Some lenders will continue to issue adjustable rate mortgages on an annual basis using market data collected from the CMT T-Bill index.
- **Sample rates and scenarios provided for illustration purposes only and are not intended to provide mortgage or other financial advice specific to the circumstances of any individual and should not be relied upon in that regard. Guaranteed Rate, Inc. cannot predict where rates will be in the future.To understand the terms of repayment and review representative examples please review the information here.
- Sample payment does not include taxes, insurance or assessments. Mortgage Insurance Premium (MIP) is required for all FHA loans and Private Mortgage Insurance (PMI) is required for all conventional loans where the LTV is greater than 80%.
- Mortgage interest rates shown are based on a 60-day rate lock period.
- The displayed Annual Percentage Rate (APR) is a measure of the cost to borrow money expressed as a yearly percentage. For mortgage loans, excluding home equity lines of credit, it includes the interest rate plus other charges or fees (such as mortgage insurance, discount points, and origination fees). For home equity lines, the APR simply reflects the interest rate. When shopping for a mortgage, you can use the APR to compare the costs of similar loans between lenders.
- The estimated total closing costs above do not constitute and are not a substitute for a loan estimate, which includes an estimate of closing costs, than you will receive once you apply for a loan. The amounts provided above for Estimated Total Closing Costs, are estimations based on the state selected. This is NOT a mortgage loan approval or commitment to lend. The actual fees, costs and monthly payment on your specific loan transaction may vary, and may include city, county or other additional fees and costs.
- These mortgage rates are based upon a variety of assumptions and conditions which include a consumer credit score which may be higher or lower than your individual credit score. Your loan's interest rate will depend upon the specific characteristics of your loan transaction and your credit history up to the time of closing.
- For adjustable-rate loans, your monthly principal and interest payment will be fixed for a period of time, and then may change based on annual interest rate adjustments. Before choosing an ARM, you should decide if you can manage the maximum estimated payment if the rate increases. To fully understand minimum and maximum payments, please speak to a mortgage loan expert.