5/1 ARM VS. 30 Year Fixed

5/1 ARM VS. 30 Year Fixed

Mortgage rates look great right now—especially if you compare them to three decades ago when the average 30-year fixed-rate mortgage offered a rate of 10.34 percent. If you go back further, to 1981, rates reached an eye-popping 18.45 percent.

But even in today’s low-rate environment, locking in your rate for 30 years isn’t always the best choice. Here’s what you need to know about when to secure a 30-year fixed mortgage versus a 5/1 adjustable rate mortgage.

The gold standard: a 30-year fixed

The 30-year fixed-rate mortgage was introduced at the end of the Great Depression to make home ownership accessible. At the time, only one in 10 people owned homes. But by offering a loan with low payments stretched out over 30 years, at a predictable, fixed interest rate, homeownership suddenly become affordable.

Today, the 30-year fixed mortgage is still the most popular home loan. In fact, in a recent survey by the Mortgage Bankers Association, adjustable rate mortgages made up only 5.2 percent of total mortgage applications. It’s easy to understand why borrowers have been flocking to fixed-rate loans instead. Rates today remain just above record lows at about 4 percent but are expected to drift higher. If you anticipate staying in your house for many years, this could be the last chance to lock in a truly excellent rate.

When to go with a 5/1 ARM

There are at least two compelling scenarios when a 5/1 ARM makes sense: when rates are high but expected to drop, or if you don’t expect to stay in your house for more than five years.

Read about:   Which Mortgage is Better? 15 vs 30 Year Home Loan Comparison Calculator

Here’s why: The 5/1 ARM comes with a fixed rate for five years and adjusts annually for the following 25 years. Because the borrower takes on more interest-rate risk starting in year six, the lender gives the borrower a break, or teaser rate, for the first five years. Right now, for instance, the average 30-year, fixed-rate loan comes with a 4.04 percent interest rate, compared with just 3.46 percent for the average 5/1 ARM.

What does that mean in terms of monthly payments? Let’s say you buy a $250,000 house with 20 percent down. With a 30-year, fixed-rate mortgage, you’d pay $949.45 per month. With a 5/1 ARM, you’d be out of pocket $893.63—or $55.82 less a month. Over five years, you’d save $3,349. That’s a substantial amount.

What if rates go up a lot?

Clearly, the risk with a 5/1 ARM is that rates go up substantially and you have decided you aren’t ready to move. Even if you’re not ready to sell for another year or two, most ARMs place caps on interest-rate hikes.

If your cap is, say, 2 percentage points per year, your rate could go up at most from 3.46 percent to 5.46 percent, leaving you in year six with a higher payment of $1,130.56—or $181.11 more than you would have paid monthly if you had locked in a fixed-rate mortgage. After one year of higher payments, you’d still be ahead in terms of total payments with the 5/1 ARM over the 30-year fixed-rate mortgage. However, by year seven, you would need to sell or refinance at a lower rate—or you may end up regretting that you didn’t lock in for 30 years.

Read about:   EagleBank - Loans

26 thoughts on “5/1 ARM VS. 30 Year Fixed

Leave a Reply

Your email address will not be published.