What to Know About 5/1 and 5/6 ARM Loans
Elevated home prices and rising interest rates have renewed interest in home loans that can lower monthly mortgage payments, like adjustable-rate mortgages (ARM). If you’re shopping for a home, you owe it to yourself to understand this mortgage option.
The most common type of these adjustable-rate mortgages has traditionally been the 5/1 ARM. However, mortgage lenders have recently changed the way they offer the conventional version of these adjustable-rate mortgage loans, and now typically offer a 5/6 ARM. While 5/1 ARMs and 5/6 ARMs are similar and designed for the same type of borrower, there are a few differences you should understand.
What is a 5/1 ARM?
A 5/1 ARM is a type of mortgage that features a variable rate. It has a fixed interest rate for its first five years. After that, the interest rate changes once a year. That’s why it’s referred to as “5/1.”
“The initial fixed interest rate with an ARM is usually lower than what is available with a conventional 30-year fixed-rate mortgage,” says Jessica Visniskie, SVP, capital markets, AmeriSave. “However, once the rate begins to adjust, it may go either up or down. So you risk having a higher monthly mortgage payment in the longer term.”
The rate adjusts based on a financial index that the lender should identify in your mortgage contract. Indexes commonly used include the Secured Overnight Financing Rate (SOFR) and the Constant Maturity Treasury (CMT) . Lenders have also historically used the London Interbank Offered Rate (LIBOR), but that index will no longer be used in the US after June 2023.
When it’s time to make an adjustment, the lender adds their chosen index’s rate to a margin listed in your mortgage contract. Note that while the index rate varies, the margin typically remains set for the life of the loan.
Suppose the index rises to 5.0% when it’s time for the next adjustment. The interest rate will rise accordingly.
Why 5/1 ARMs are transitioning to 5/6 ARMs
Conventional U.S. ARM loans, including 5/1 ARMs, have historically used the LIBOR as their index. However, due to suspicious practices that rigged the index rates, LIBOR will be phased out by June 2023 . Lenders are switching to other indices that are more accurate at measuring the cost of borrowing like the SOFR for their conventional ARM loans. Because SOFR is a six-month average, these loans now typically have a six-month adjustment period — and you’ll find lenders offering 5/6 ARMs instead of 5/1 ARMs.
Note that government-backed ARM loans, including those available from the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA), are still available as 5/1. These loans use the CMT index, which accommodates a one-year adjustment period.
Interest rate capping for ARM loans
Regardless of how your ARM loan is structured — whether it’s a 5/1, a 5/6, or any of the other types of ARMs — its adjustable interest rate may be subject to caps. These do just what you might think — they limit the amount your interest rate can increase.
• Initial rate cap — Limits the number of percentage points that can be added to the interest rate upon its first adjustment.
• Periodic rate cap — Limits the number of percentage points that can be added to the interest rate upon subsequent adjustments.
• Lifetime rate cap — Limits the number of percentage points that can be added in total during the life of the loan.
Interest rate caps are expressed as three numbers separated by slashes, such as 5/2/5. The first 5 is for the initial cap, the 2 is for the periodic cap, and the final 5 is the lifetime cap.
“An ARM loan isn’t for everybody,” says Visniskie. “However, if you plan to stay in the home for just a few years, it may be a great borrowing option. Alternatively, you can get an ARM and refinance the loan to a fixed-rate loan before the adjustment period starts. You’d ideally do this when interest rates drop below those available when you bought the home.”
How does a 5/6 ARM work?
Let’s look at an example to illustrate better how a 5/6 ARM works.
You sign a purchase contract for a $400,000 home and have enough saved to make an $80,000 (20%) down payment.
Your lender offers two options for your mortgage:
• A 30-year fixed-rate loan at a 7.0% interest rate
• A 5/6 ARM at a 6.0% introductory interest rate and 5/2/5 interest rate capping for the adjustment period.
Here’s how those loans would compare in their first five years.
**Total payments will be dependent on rate moves after year 5
The 5/6 ARM in this example saves you $159 per month or $12,600 in the first five years (60 months) of the mortgage. So opting for a 5/6 ARM if you plan to move before the adjustment period ends can save you a lot of money.
But what if you decide to stay put after five years? It all depends on how the interest rate adjusts. Suppose the interest rate on the 5/6 ARM increases two percentage points to 8.0% at its first adjustment. In that case, the monthly payment will increase to $2,348, or $219 more than the fixed-rate mortgage. If it jumps another half point to 8.5% in a subsequent adjustment period, the monthly payment will increase to $2,461, or $332 more than the fixed-rate mortgage monthly payment. Your savings would be wiped out quickly.
Of course, the 5/6 ARM interest rate could stay flat or decrease, saving you more money than the fixed-rate loan. But nobody can accurately predict what will happen with interest rates five years from now.
You do have some peace of mind with the interest rate caps, which prevent the loan from increasing more than 2 percentage points in a year, or 5 percentage points over the life of the loan, but then you run the risk of negative amortization if your loan payments don’t cover the cost of interest.
5/1 ARMs vs 5/6 ARMs
For the borrower, the most important difference between a 5/1 ARM and a 5/6 ARM is the length of the period between interest rate adjustments. A 5/1 ARM uses a one-year period. A 5/6 ARM uses a 6-month period.
In fact, the example above would work the same for either loan type. The only difference is that you’d see an interest rate adjustment every six months with a 5/6 ARM.
Refinancing a 5/6 (or 5/1) ARM to a fixed-rate mortgage
To avoid living with an unpredictable interest rate and fluctuating monthly mortgage payment, many people who get ARMs and plan to stay in their home for the long-term refinance to a fixed-rate mortgage.
Let’s continue our example.
At the five-year mark, the interest rate on a 30-year fixed-rate mortgage drops to 4.25%. You’ve built up about $100,000 worth of equity, and your home’s appraised value is now $425,000. You contact the lender and apply to refinance your 5/6 ARM to a 30-year fixed-rate mortgage.
In this ideal scenario, you save money with the 5/6 ARM in the first five years of the mortgage. You’re also now paying substantially less than if you’d chosen the fixed-rate loan when you bought your home. Furthermore, the total cost to pay off the two mortgages is less than the cost of the original 30-year loan.
Saving money when refinancing a 5/6 ARM takes some planning. “You should do a bit of an ROI calculation,” says Visniskie. “Maybe you know that your rate will go up if you stay in the ARM. But refinancing also means closing costs. So you should estimate how many years you’ll need to recoup those costs based on the interest rate you’ll have with a fixed loan. A loan officer can help you work through this ROI when you’re ready to make these decisions.”
ARM loan types
The 5/6 is not the only type of ARM to consider. In fact, your lender may offer several types of adjustable-rate loans:
• 5/6: Five-year fixed period; rate adjusts every six months afterward
• 7/6: Seven-year fixed period; rate adjusts every six months afterward
• 10/6: Ten-year fixed period; rate adjusts every six months afterward
• 5/1, 7/1, 10/1: Five, seven, or ten-year fixed period; rate adjusts every year afterward. AmeriSave offers these options only as FHA or VA loans. They may eventually transition to six-month adjustments with the retirement of LIBOR.
• Interest-only ARM — You pay only the interest portion of the loan for a set period, which may last from a few months to a few years. Afterward, you pay both principal and interest according to an amortization schedule that will have the loan paid off by the end of its term.
• Payment-option ARM — You can choose from several monthly payment options, including a 15-, 30-, or 40-year amortizing payment, an interest-only payment, or a minimum payment.
Pros and cons of 5/6 ARMs
A 5/6 ARM can be an excellent way for you to save money. But ARMs aren’t right for every homebuyer. Consider these pros and cons when you’re shopping for a mortgage.
5/6 ARM vs. 30-year fixed: Which is right for you?
Is a 5/6 ARM the right choice? It depends on your plans as a homeowner and your risk tolerance.
If you think you’ll likely move within a few years — maybe your career requires it, or you’re planning to grow your family — a 5/6 ARM can be a great way to save money with a lower mortgage interest rate. If you plan to stay in your home and are willing to trust that interest rates will drop to the point at which refinancing makes financial sense, then a 5/6 ARM might again work for you.
On the other hand, if you plan to stay in the home for a long time, prefer the assurance of a stable, fixed interest rate and payment, and don’t want to feel pressured to refinance, then a 30-year fixed mortgage might be more your speed.
How to qualify for an ARM
Most lenders have similar qualification criteria for a 5/6 ARM as with a fixed-rate mortgage.
• A minimum credit score of 620 for a conventional loan (FHA loans require a 580 minimum score).
• A minimum debt-to-income (DTI) ratio of 50.
• A minimum down payment of 5% of the sale price (FHA loans require a 3.5% minimum).
• Proof of employment and income (which may include W2 statements or paystubs).
As with any mortgage, getting preapproved for an ARM is an excellent idea. This will give you greater confidence as you start house hunting earnestly and let sellers know you’re serious as a buyer.
5/6 ARM alternatives
Maybe an ARM just doesn’t seem right for you, but you still want to save money on your mortgage. You do have options.
Here’s one final tip: Think beyond the mortgage.
Remember that your mortgage and monthly payment are among the many costs incurred when buying a home. Items such as repairs and renovations, decorating, furniture, and other needs could significantly add to your total homebuying cost.
So consider getting a personal loan after closing the mortgage to cover some or all of these needs. This would free up some cash that you could apply to the down payment on your home, lowering your monthly mortgage payment.
The bottom line
With a lower initial interest rate, a 5/1 ARM loan can be a great way to save money on your mortgage. These loans are especially worth considering if you plan to move within a few years. But even if you stay in the home for the long term, you can refinance a 5/1 ARM to a 30-year fixed-rate mortgage with a stable interest rate.
Frequently asked questions: 5/1 and 5/6 ARM loans
Do 5/1 ARM loans still exist?
Yes, 5/1 ARM loans still exist. However, you may have to get a government-backed mortgage, such as an FHA or VA, to get a 5/1.
This is because many lenders have changed the index they use to help determine the interest rates for their conventional ARM loans. Whereas they used to use the London Interbank Offered Rate (LIBOR), which lent itself to a 12-month adjustment period, they now use a funds index called the Secured Overnight Financing Rate (SOFR), which is based on a six-month average.
The bottom line? If you’re shopping for a conventional ARM loan with a five-year fixed period, you may need to get a 5/6 ARM rather than a 5/1 ARM.
Is LIBOR going away?
Yes, LIBOR is being replaced as the index for conventional ARM loans in the US. Many lenders are moving to alternative indexes, such as SOFR.
Can I refinance a 5/1 or a 5/6 ARM Loan?
Yes, it’s common to refinance any ARM loan to a fixed-rate mortgage as the fixed period ends. This allows the homeowner to have a stable interest rate and monthly mortgage payment instead of one that fluctuates periodically. Ideally, you should time your refinance so your new interest rate is lower than what was available when you bought the home.
What does “5/1” mean in a 5/1 ARM loan?
The “5” in 5/1 ARM means the mortgage has a stable introductory rate for the first five years. This is known as the “fixed period.”
The “1” in 5/1 ARM means the interest rate will adjust once per year after the initial fixed rate period ends. This is known as the “adjustment period.”
How often does the interest rate adjust on a 5/1 ARM loan?
After the five-year fixed period for a 5/1 ARM loan ends, the interest rate adjusts once per year.
How often does the interest rate adjust on a 5/6 ARM loan?
After the five-year fixed period ends, the interest rate adjusts once every six months.