What you need to know about 5/1 ARM refinance loans

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When you get a 5/1 ARM refinance, you have a fixed interest rate for five years, which adjusts annually once that period ends.Shutterstock

Mortgage refinancing options can be confusing, especially when you compare fixed-rate and adjustable-rate loans. While you may think of a mortgage refinance as a fixed-rate loan, it is possible to refinance a fixed- or adjustable-rate mortgage into a new ARM.

A 5/1 ARM refinance may make sense for you, depending on your individual circumstances. Here’s what you need to know about 5/1 ARM refinance loans.

If you’re considering refinancing your mortgage, it’s a good idea to compare rates from multiple lenders. With Credible, you can see personalized rates in minutes.

What’s a 5/1 ARM refinance loan?

A 5/1 ARM is a type of adjustable-rate mortgage that’s a hybrid of a fixed-rate loan and a variable-rate loan. The first number represents the number of years your loan has a fixed rate. The second number specifies how often your rate can adjust after the end of the fixed-rate period. For a 5/1 ARM, that’s once a year.

It’s common to see ARM loans labeled 3/1, 5/1, 7/1 and 10/1, although 5/1 is the most popular.

A 5/1 ARM refinance is a variable-rate loan that you can take out to pay off and replace your current mortgage. You can choose to refinance with an ARM regardless of whether your original mortgage was a fixed-rate loan or another ARM.

How does a 5/1 ARM refinance loan work?

A 5/1 ARM refinance loan works the same as an ARM you take out to purchase a house. At the end of the initial five-year fixed-rate term, your loan’s interest rate will reset. After that, your interest rate — and monthly payments — can change once a year based on an index the lender uses.

If interest rates go up, you’ll end up with a higher monthly payment. If interest rates go down, you could pay less although it’s not likely to be a big decrease.

To understand how a 5/1 ARM refinance loan works, you need to know a few terms:

  • Initial interest rate — The initial interest rate is the temporary fixed rate you’ll pay for the first five years on your 5/1 ARM refinance loan. On a 10/1 ARM, you’ll see a temporary fixed rate for the first 10 years, and on a 3/1 ARM, for the first three years.
  • Adjustment period — The adjustment period indicates how often your rate could change after your initial fixed-rate period ends. With a 5/1 ARM, your interest rate could change every year for the rest of the loan term.
  • Index — The index is tied to a benchmark rate and often fluctuates with the market. Common indexes include one-year constant maturity Treasury securities and the London Interbank Offered Rate (LIBOR).
  • margin — To set your interest rate, lenders use a margin. Lenders add a few percentage points to the index rate to determine the interest you’ll pay on your ARM. Margins typically don’t vary over the life of your loan.

5/1 ARM refinance loans vs. fixed rate refinance loans

The main difference between ARM refinance loans and fixed-rate refinance loans is that with an ARM, your rate is only temporarily fixed. With a 5/1 ARM, your rate is fixed for the first five years. After that, your rate adjusts every year. On the other hand, with a 30-year fixed-rate refinance loan, your rate is fixed over the life of your loan and never fluctuates.

Is there a rate cap for 5/1 ARM refinance loans?

Most ARMs have rate caps that limit how much a rate can change after your temporary fixed-rate period ends. One common cap structure is the 2/2/5 cap.

  • the initial adjustment cap limits the amount your rate can go up the first time your rate adjusts. With the 2/2/5 cap, your initial cap is 2%, meaning the first adjustment to your rate can’t be more than 2% higher than your initial interest rate.
  • Subsequent adjustment caps restrict how much your interest rate can increase for later adjustments. As with initial adjustment caps, subsequent adjustment caps are 2% with the 2/2/5 structure.
  • Lifetime caps, typically required by law, stipulate how much a rate can adjust over the entire term of your loan. Your interest rate typically can’t go more than 5% above your initial rate (the “5” in 2/2/5).

Credible makes it easy to compare mortgage refinance rates from multiple lenders, without affecting your credit.

Should you get a 5/1 ARM refinance loan?

In some situations, it can make sense to refinance into an ARM rather than a fixed-rate loan, including:

  • A lower monthly payment is your top priority.
  • You plan to move or change jobs within five years of refinancing your mortgage.
  • You’ll be able to finish paying off your refinanced mortgage before the rate resets.

A lower interest rate may also allow you to pay down your mortgage sooner and build equity in your home faster. If you’re close to retiring, you may consider refinancing your mortgage to lower your interest rate and save money each month.

But if you plan to stay in your home long-term, know you won’t be able to pay off the loan before it resets, or aren’t sure you’ll be able to refinance again, a 5/1 ARM refinance may not be right for you.

5/1 ARM refinance loan pros and cons

As with any refinancing option, you need to consider the pros and cons of a 5/1 ARM:

pros

  • Lower initial interest rate — For the first five years of your loan, you’ll get a lower interest rate and monthly payment than you would with a 30-year fixed-rate loan.
  • Interest rate could drop — After the temporary fixed-rate period, your payment could decrease if rates drop.
  • Faster loan repayment — A lower rate allows you to apply the monthly savings toward the principal and pay off your loan sooner.

Cons

  • Interest rate could rise — After the initial fixed-rate period of your 5/1 ARM, your interest rate could increase. This could cause “payment shock,” meaning your monthly payment is suddenly much higher than expected.
  • Makes budgeting harder — Your monthly payments can fluctuate every year after the fixed-rate period ends, which can make it difficult to budget.
  • May pay more in overall interest — If you plan to stay in your home for a long time, you may end up paying more in interest after the fixed-rate period on your 5/1 ARM refinance than you would with a long-term fixed-rate mortgage.

What are the eligibility requirements for 5/1 ARM refinance loans?

Requirements for a 5/1 ARM refinance loan are much the same as for fixed-rate loans. To get the lowest rate, you’ll likely need a minimum credit score of 620. But because an ARM has a lower monthly payment in the first five years, it can be easier to qualify based on your credit.

Lenders look at your employment history, prior years’ taxes, and income. Many lenders want to see that your monthly payment doesn’t exceed 28% of your gross income. Because it’s a refinance, you’ll also need sufficient equity built up in your home, ideally 20% minimum. If you have less equity than that, you’ll have to pay private mortgage insurance (PMI) until you reach that point.

Credible makes it easy to compare mortgage refinance offers from multiple lenders.

5/1 ARM refinance loan FAQs

Read on for the answers to a few common questions about 5/1 ARM refinance loans.

What should you look for in a 5/1 ARM refinance loan?

Like any refinance loan, you’ll want to consider the interest rate, especially the rate you’ll pay in the first five years of your 5/1 ARM. Also look at rate caps and margins set by your lender. Some ARMs come with prepayment penalties and other fees when you refinance your loan. Fees vary, so consider how much you’ll end up paying upfront or rolling into your loan in closing costs.

What should you do if your interest rate increases?

You’ll receive notice from your lender before an interest rate increase on your 5/1 ARM. When you receive this notice, you can choose to refinance to another ARM or to a fixed-rate mortgage. If you plan to stay in your home for many years, a fixed-rate mortgage might be the best choice.

But if you plan to move within the fixed-rate period of your ARM, then refinancing to another ARM may be preferable. Remember, your payment will likely change after the fixed-rate period ends, and lenders charge closing costs when you refinance your mortgage, so consider your budget when making this decision.

What’s a 5/1 ARM interest-only loan?

With an interest-only 5/1 ARM, none of the payments you make each month during a certain period go toward paying down the principal balance. The interest-only period varies, but might last from several months to many years. After this interest-only period, your mortgage will amortize so it’s paid off by the end of your term.

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